Information Risk and Capital Structure

In this paper, we investigate the effects of information asymmetry across equity investor groups as an explanation for the capital structure decisions of the firm. We test empirically whether differences in information across outside investors have any bearing on the leverage ratios of firms and on their choice of financing instrument when raising external capital. We use the probability of information-based trading (PIN) estimated using trade based data to test our theory. We find that firms with higher information risk (extrinsic information asymmetry across groups of investors) measured using PIN have higher market leverage. Extrinsic information asymmetry also seems to play a significant role in the firm's decision to issue debt or equity when raising capital, with high PIN firms more likely to issue debt. Comparing firms that issued debt and repurchased equity in the same year (increased leverage) with those that issued equity and repurchased debt in the same year (decreased leverage), we find firms with higher extrinsic information asymmetry are more likely to increase their leverage. These results strongly support the hypothesis that information risk affects capital structure after controlling for information asymmetry between firm managers and outside investors.