Question

5. Briefly describe the asymmetric information theory of capital structure. What are its implications for financial managers?

Answer 1

To present a new perspective on the traditional pecking order theory, a theory of capital structure in which costs associated with asymmetric information are the primary friction is used. The model considers both the amount of debt and the restrictiveness of the related debt covenants to be part of the debt structure, allowing for a more comprehensive interpretation of the capital structure. The option of leverage, the restrictiveness of the related debt covenants and the renegotiation of the covenants are explored and empirical consequences established.

The standard corporate capital structure trade-off theory considers the distribution of cash flow between debt and equity securities to be the primary influence of the choice of capital structure. Considering the impact of this allocation on taxation, bankruptcy costs, opportunities for decision-making, knowledge transmission, or other frictions, an equilibrium is found. Consider a company with uncertain cash flow facing asymmetric information between the company and the market. A capital-constrained entrepreneur seeks financing from an inferiorly educated capital market to develop the company.
Asymmetric knowledge at the time of funding and illustrate that current equity holders profit from the selling of low sensitivity securities (debt). However, their model does not consider post-financing decision-making nor the impact of the initial funding scheme on such decisions.

The use of debt covenants will not control the incentive problem perfectly because if the debt is risky, the incentives of the lender will also be distorted and the lender makes decisions based on inferior information.
When assessing the capital structure of the company, the risk of ex post fluctuations in the decision-maker's incentives caused by the use of debt financing is balanced against the adverse selection advantages of ex ante debt sale.