Using an information asymmetry index based on measures of adverse selection developed
by the market microstructure literature, we test if information asymmetry is the
sole determinant of capital structure decisions as suggested by the pecking order
theory. Our tests rely exclusively on measures of the market's assessment of adverse
selection risk rather than on ex-ante firm characteristics. We find that information
asymmetry does affect capital structure decisions of U.S. firms over the period 1973-2002,
especially when firms' financing needs are low and when firms are financially constrained.
We also find a significant degree of intertemporal variability in firms' degree of
information asymmetry, as well as in its impact on firms' debt issuance decisions.
Our findings based on the information asymmetry index are robust to sorting firms
based on size and firm insiders' trading activity, two popular alternative proxies
for the severity of adverse selection. Overall, this evidence explains why the pecking
order theory is only partially successful in explaining all of firms' capital structure
decisions. It also suggests that the theory finds support when its basic assumptions
hold in the data, as it should reasonably be expected of any theory.