The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

Question

Quizplus · Accepted Answer

The asymmetric information explanation of capital structure actually suggests that firms prefer to issue debt rather than equity when they believe their stock is undervalued, because issuing equity under such conditions would dilute the value for existing shareholders. The negative signal is associated with issuing new equity, not debt.

The Asymmetric Information Explanation of Capital Structure Suggests That Firms