Corporate Finance - Signaling Prospects Through Financing Decisions

One of the key assumptions Modigliani and Miller make in their work is that market information is symmetric, meaning companies and investors have the same information with respect to the company's future projects/investments. This assumption, however, is not realistic. When making capital decisions, a company's management should have more information than an investor, which implies asymmetric information.

A financing decision is a way in which a company can inadvertently signal its prospects to investors. For example, suppose Newco decides to finance a new project with equity. Newco's additional equity would in fact dilute stockholder value. Since companies typically try to maximize stockholder value, would an equity offering be a bad signal? The answer is yes.

There would be some benefit from the project to the stockholders; however, the dilution from the offering would offset some of that benefit. If a company's prospects are good, management will finance new projects with other means, such as debt, to avoid giving any negative signals to the market.

Look Out!
Financing a capital project with equity may be a signal to investors that a company's prospects are not good.
Degree of Total Leverage


Related Articles
  1. Professionals

    The Agency Problem

    We look at the different positions in an organization and investigate the problems that can arise between managers, creditors and stockholders.
  2. Professionals

    Stock Dividends and Repurchases

    CFA Level 1 - Stock Dividends and Repurchases. Learn how stock dividends can affect a company's share price. Covers advantages and disadvantages of stock dividends, splits and repurchases.
  3. Professionals

    Agent-Principle Relationship

    CFA Level 1 - Agent-Principle Relationship. Learn about the agent-principal relationship and agency problems. Discusses the problem and ways to motivate the agent.
  4. Professionals

    Dividend Growth Rate and the Effect of Changing Dividend Policy

    CFA Level 1 - Dividend Growth Rate and the Effect of Changing Dividend Policy. Learn how to calculate the dividend growth rate. See how the clientele effect and signalling affect changes in dividend ...
  5. Entrepreneurship

    Is Equity Financing the Right Choice for Your Business?

    Discover the benefits and drawbacks of equity financing for a small business, and learn when equity financing should be used instead of debt financing.
  6. Investing

    What is Equity Financing?

    Companies that are short on cash may need financing to pay for short-term needs or long-term capital expenditures.
  7. Professionals

    Effects of Debt on the Capital Structure

    CFA Level 1 - Effects of Debt on the Capital Structure. How much debt should a company have in its capital structure? This section highlights the benefits and costs of incorporating more debt.
  8. Professionals

    The Dividend Discount Model (DDM)

    CFA Level 1 - The Dividend Discount Model (DDM). Learn the relationship between dividends and security values. Provides formulas for various dividend discount models.
  9. Professionals

    Types of Risk

    CFA Level 1 - Types of Risk. Learn the three types of risk associated with capital budgeting. Covers stand-alone, corporate and market risk.
  10. Professionals

    Shareholders' (Stockholders') Equity Basics

    CFA Level 1 - Shareholders' (Stockholders') Equity Basics. This section covers the various types of equity. Learn the priority order of equity, in case of a firm's liquidation.
RELATED TERMS
  1. Equity Financing

    The act of raising money for company activities by selling common ...
  2. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  3. Project Finance

    Defined by the International Project Finance Association (IPFA) ...
  4. Expanded Accounting Equation

    The expanded accounting equation is derived from the accounting ...
  5. Stockholders' Equity

    The portion of the balance sheet that represents the capital ...
  6. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
RELATED FAQS
  1. Does stockholders equity accurately reflect a company's worth?

    Learn whether stockholders' equity accurately reflects a company's worth. Stockholders' equity is found by taking the difference ... Read Answer >>
  2. What are the benefits for a company using equity financing vs. debt financing?

    Learn what some of the principal advantages are for a company that chooses to utilize equity financing in preference to debt ... Read Answer >>
  3. Is par value or market value more important to stockholder equity?

    Find out about stockholders' equity, how to calculate it, and whether par or market value of stock is more important to stockholders' ... Read Answer >>
  4. What does total stockholders equity represent?

    Understand the equation for total stockholders' equity and what it represents. Learn the components of stockholders' equity ... Read Answer >>
  5. How does additional equity financing affect existing shareholders?

    Learn about how equity financing affects existing shareholders. By issuing and selling shares on the open market, equity ... Read Answer >>
  6. Do stock splits and stock dividends affect stockholder equity?

    Learn about stockholders' equity, stock splits and stock dividends and why stock splits and stock dividends do not affect ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center