Final answer:
Asymmetric information leads companies to raise external funds by borrowing instead of issuing common stock due to the managers' knowledge advantage and the ability to retain control and ownership. Issuing common stock would require disclosing detailed information and could reduce the information advantage.
Step-by-step explanation:
Asymmetric information is when there is a difference in knowledge between buyers and sellers. In the context of companies raising external funds, managers usually have more information about their company's prospects, risks, and values than outside investors. This asymmetry of information makes it more advantageous for companies to raise funds by borrowing rather than issuing common stock.
When managers have more knowledge about their company, they can make informed decisions about the risks and rewards associated with borrowing. They can negotiate better terms and interest rates with lenders. Moreover, borrowing allows managers to retain control and ownership of the company, as issuing common stock would dilute their ownership.
On the other hand, if companies were to issue common stock, they would need to disclose detailed information about their prospects, risks, and values to potential investors. This would reduce the information advantage of the managers and may negatively impact the company's ability to negotiate favorable terms or retain control.