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How does asymmetric information affect the firm's capital structure decisions?

Question:

How does asymmetric information affect the firm's capital structure decisions?

Capital structure:

The proportion of an organization's equity and debt, which is required for operations as well as growth, is known as a capital structure. It enables the organization to make better decisions about using funds and finances.

Answer and Explanation:

Managers of the organization have additional information as compared to the investors. These facts drive the decisions concerning the capital structure. When in an organization, cash is required for a new project or development, an optimistic manager will try to finance the capital through debt financing or issuing shares. Hence as long as borrowing expense is less, managers will choose debt rather than equity financing.

On the contrary, when comes to pessimistic manager will try to finance the capital through equity but when asymmetric information related to sudden decline in stock price is available the pessimistic manager too will go for debt financing.


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Capital Structure & the Cost of Capital

from Finance 101: Principles of Finance

Chapter 15 / Lesson 1
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