Information Asymmetry about Investment Risk and Financing Choice

• DOI: http://doi.org/10.1111/jbfa.12128
• Published date: 01 September 2015
• Date: 01 September 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(7) & (8), 947–964, September/October 2015, 0306-686X

doi: 10.1111/jbfa.12128

Information Asymmetry about Investment

Risk and Financing Choice

MUFADDAL BAXAMUSA,SUNIL MOHANTY AND RAMESH P. RAO∗

Abstract: Though it is generally accepted that information asymmetry has an impact on

capital structure policy, the nature of the information asymmetry is not well understood. Recent

theoretical work and empirical evidence suggests that financing choice depends upon the

information asymmetry associated with the investment risk of the particular use of proceeds.

Consistent with this view, using the sources and uses of funds framework, we find that equity

is used to fund projects with greater information asymmetry about their risk such as research

and development expenditure, while debt is used to fund investments with lower information

asymmetry about their risk such as liquidity enhancement.

Keywords: firm investment, capital structure, information asymmetry

1. INTRODUCTION

The role of information asymmetry in corporate financing has become one of the

basic tenets of capital structure theory. The most enduring version is the popularly

known pecking order (PO) hypothesis posited by Myers and Majluf (1984). The model

predicts that information asymmetry between managers and investors leads to adverse

selection costs, creating a hierarchy of financing preference based on the information

sensitivity of the security. In this scheme, retained earnings are the least information

sensitive, followed by debt, and then external equity. Thus, firms are inclined to fund

their financing deficit first by retained earnings, then by debt issuance, and only as a

last resort by external equity issuance. The intensity of research in this area is only

matched by the lack of empirical consensus for the PO theory.1For example, the

∗The first author is at Department of Finance, Opus College of Business, University of Saint Thomas, St

Paul, MN. The second author is at Department of Finance, Brooklyn College, City University of New York,

Brooklyn, NY. The third author is at Department of Finance, Spears School of Business, Oklahoma State

University, Stillwater, OK. We would like to thank Rajesh Aggarwal, Alice Bonaime, Richard S. Warr, Abu

Jalal, Sheridan Titman, Puneet Jaiprakash, Hafez Hussain and Jack Wolf for their comments. Wealso thank

seminar participants at the 2010 Financial Management Association, 2011 Eastern Finance Association, 2012

Financial Management Association-Europe, and 2012 Asian Finance Association meetings for providing

useful comments on earlier drafts. We would like to thank Subbu Iyer for his research assistance. (Paper

received December 2014, revised version accepted July 2015).

Address for correspondence: Ramesh P.Rao, Department of Finance, Oklahoma State University, Stillwater,

OK, USA.

e-mail: ramesh.rao@okstate.edu

1 Shyam-Sunder and Myers (1999) find some support for the PO theory while Frank and Goyal (2003),

Fama and French (2002, 2005), Wu and Wang (2005) and Leary and Roberts (2010) find significant

evidence against it.

C

2015 John Wiley & Sons Ltd 947

948 BAXAMUSA, MOHANTY AND RAO

PO theory cannot explain why young, small and non-dividend paying firms that face

large asymmetric information problems, issue equity securities (e.g., Ambarish et al.,

1987; Fama and French, 2002; and Wu and Wang, 2005). Survey findings of Graham

and Harvey (2001) also suggest that small and non-dividend paying firms’ financing

decisions are not consistent with PO theory.

Though evidence in favor of PO is mixed, Leary and Roberts (2010) suggest

that measures of information asymmetry may be systematically related to financing

behavior, albeit not necessarily in sync with the predictions of the PO model.

Specifically, some of the observed patterns with respect to small firms, age, and asset

tangibility suggest that information asymmetry relating to future investments may play an

important role. Recent theoretical work by Fulghieri and Lukin (2001), Wu and Wang

(2005), Halov et al. (2011) and Halov and Heider (2012) provides support for such

a view. These models predict a preference for equity over debt when there is greater

information asymmetry between the firm and outsiders about future investment risk

(i.e., project risk to which the funds are directed). Wu and Wang (2005) also show that

announcement returns associated with issuance of equity are more likely to be positive

when the asymmetric information about firm value arises mainly from growth (future

investment) rather than assets-in-place.

In this paper, we provide empirical evidence to support the notion that the

information asymmetry of the underlying project risk (e.g., relative success of a new

product such as a new drug or the growth potential from a plant expansion) is

what drives financing choice. For testing purposes, we classify investments into a

hierarchy based on their underlying risk information asymmetry: liquidity investments

(lowest risk), capital expenditures (moderate risk) and R&D investments (highest

risk). We argue that liquidity-enhancing investments (e.g., building up cash or working

capital) are associated with fairly low information asymmetry about their risk while,

at the other extreme, investments in R&D are expected to be associated with the

greatest information asymmetry about their project risk. On the other hand, as capital

expenditures tend to be focused on investments in fixed assets, they are assumed to

hold an intermediate position between liquidity-enhancing investments and intangible

investments (i.e., R&D expenditures). Thus, we expect debt financing to be associated

with subsequent low risk information asymmetry liquidity-enhancing investments while

equity financing should be more closely related with high underlying risk information

asymmetry investments such as R&D.

For our empirical methodology we employ the sources and uses of funds framework

used in several studies (e.g., Gatchev et al., 2010; Chang et al., 2014) based on the

accounting identity that the total funds used by the firm should equal internal cash

flows in addition to debt and equity raised by the firm. The primary uses of funds

we consider are research and development expenditure (R&D), capital expenditure,

working capital changes, changes in cash holdings and cash dividends.2We find that

per dollar of equity issued 22 cents is used for R&D, while only 1 cent per dollar of debt

goes toward R&D financing. With respect to capital expenditures, 11 cents of every

dollar of debt financing is devoted to this expenditure in contrast to only 5 cents in the

case of equity financing. A similar pattern is evident for working capital expenditures

where 9 cents of every dollar of debt financing ends up but only 3 cents in the case of

2 Though our focus is on investment related uses of funds, we include dividends to meet the cash flow

identity requirement.

C

2015 John Wiley & Sons Ltd