Abstract
This paper develops a theory of firms' debt-equity choice based on the role of risk in the adverse selection problem of external financing. When risk matters, debt cannot be optimal since it is a concave claim whose value to uninformed investors depends critically on risk. This means that Myers and Majluf (1984)'s pecking order is a special case that only applies when risk does not matter (or is perfectly known). Firms should issue less debt and more equity when risk matters since it reduces the concavity of the outside claim. Unlike existing asymmetric information theories of capital structure, this analysis can explain why small young non-dividend paying firms issue more equity-like securities.
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