Asymmetric information

Costs of asymmetric information refer to costs resulting from the fact that managers typically have more information about a company’s prospects and future performance than shareholders or creditors. Firms with complex products or little transparency in financial statements tend to have higher costs of asymmetric information, which results in higher required returns on debt and equity capital.

Because shareholders and creditors are aware that the management know more than they do, these investors will try to infer “signals” from the management’s actions. Specifically, taking on debt financing is making a commitment to make fixed interest payments, and is usually a sign of manager confidence in having future cash flows that are able to meet these obligations. Issuing equity, on the other hand, is typically viewed as a negative signal that managers believe the firm’s stock is overvalued.

See also: Pecking order theory