Debt vs. Equity and Asymmetric Information: a Review

DEBT vs. EQUITY AND ASYMMETRIC INFORMATION:
A REVIEW

Linda Schmid Klein, University of Connecticut
Thomas J. O’Brien*, University of Connecticut

Stephen R. Peters, University of Cincinnati

March 2002; Forthcoming, The Financial Review

*Corresponding author: Department of Finance, University of Connecticut, 2100 Hillside Rd., Storrs, CT
06269-1041; Phone: [phone]; Fax: [phone]; E-mail: [e-mail]
Acknowledgements: The authors thank Ivan Brick, Shanta Hegde, Tim Manuel (especially), and Steve
Wyatt for reading the paper and for insightful comments.
Abstract: Recent Nobel Prizes to Akerlof, Spence, and Stiglitz motivate this review of basic concepts and empirical evidence on information asymmetry and the choice of debt vs. equity. We first review the literature that holds investment fixed. Then we review capital structure issues related to the adverse investment selection problem of Myers-Majluf. Finally, we discuss the timing hypothesis of capital structure. Empirical studies do not consistently support one theory of capital structure under information asymmetry over the others. Thus, the review suggests that additional theoretical contributions are needed to help understand and explain findings in the empirical literature.
Keywords: capital structure, asymmetric information, pecking order hypothesis, timing hypothesis
JEL Classifications: G30/G32

Debt vs. Equity and Asymmetric Information: A Review

1.

Introduction
George Akerlof, Michael Spence, and Joseph Stiglitz received the 2001 Nobel Prize for

introducing an enduring set of tools to examine the economic impact of asymmetric information.
The tools have been used to open vast research agendas in many areas of economics, including corporate finance.
In corporate finance, asymmetric information refers to the notion that firm insiders, typically the managers, have better information than do market participants on the value of their firm’s assets

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