Asymmetric Information, Debt Capacity, and Capital Structure

Abstract

Capital structure choice based on costs associated with asymmetric information is examined in order to present a new perspective on the standard pecking order and trade-off theories. In the model, both the face value of debt and the restrictiveness of the associated debt covenants are chosen as part of the financial structure, allowing a more complete characterization of this decision. Debt structure choice balances ex ante adverse selection against ex post moral hazard, providing a natural integration of the pecking order and trade-off theories and the development of interesting empirical implications.