The Journal of Applied Business Research – January/February 2014 Volume 30, Number 1 Copyright by author(s); CC-BY 173 The Clute Institute Adverse Selection, Debt Capacity And Corporate Growth: An Industry Life Cycle Perspective Hasna Chaibi, University of Tunis, Tunisia ABSTRACT This paper examines the industry impact on financing corporate growth. According to underinvestment and overinvestment problems, firms are more likely to have less debt capacity in their growth stage of life cycle. However, it is known that new economy firms have higher levels of growth rate, return and risk, and particularly undertake more technical projects. Therefore, I test the hypothesis that debt capacity during the growth stage of life cycle is affected by New Economy. My empirical analysis covers U.S. companies listed on NYSE, AMEX and NASDAQ in the period of 1990-2010. I find that growth firms have significantly smaller debt capacity. Nevertheless, supporting the life cycle theory of financing that emphasizes the adverse selection problem faced by new economy firms, this link tends to be less prominent in the new economy industry. The results complement prior studies that have found significant relationship between firm growth and corporate debt capacity by confirming the important role played by the industry membership (New Economy) in determining the intensity of this relation. Keywords: Adverse Selection; Debt Capacity; Corporate Growth; Life Cycle Theory of Financing 1. INTRODUCTION t is often argued that firms use less debt in their capital structure during their growth stage of life cycle (Billet et al., 2007; Rajan & Zingales, 1995; Gaver & Gaver, 1993; Smith & Watts, 1992). This paper tests if the debt financing decision in growth stage is affected by the industry of “new economy.” The purpose of this study is to explore the impact of industry membership on the debt financing decision of firms in their growth phase. As documented by Ittner et al. (2003), new economy firms (NEFs) differ in many respects from traditional ones (old economy firms, OEFs). Actually, NEFs are smaller, pursue riskier strategies, have significantly lower accounting returns, and are undertaking more extensive research and development than OEFs. More importantly, one distinctive feature of these firms is their more opaque and technical projects. Financing decision varies across firms as a function of the firm life cycle stages. Firms have lower debt-to- equity ratios in the growth stage of life cycle. In this area, Smith and Watts (1992) and Gaver and Gaver (1993) provided initial evidence that growth firms use less debt in their capital structure. Rajan and Zingales (1995) extended these studies by demonstrating that the negative relationship between leverage and the market-to-book ratio, the proxy for growth options, is statistically significant across seven countries, including the United States. Goyal et al. (2002) found that U.S. defense firms increase their use of debt capacity as their growth declines. Billet et al. (2007) concluded that firm growth directly affects the corporate debt in a negative direction. Although the above studies confirm the inverse association between firm growth and debt capacity, none has examined the industry impact on this relationship. Based on the life cycle theory of financing (Berger & Udell, 1998), I examine empirically if the effect of industry membership (new economy industry vs. old economy industry) tends to attenuate the negative impact of firm growth on debt capacity. I use a leverage equation including growth I