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. Investing

    What Is Stockholders' Equity?

    Stockholders’ equity represents the equity that shareholders own in a company.
  2. Small Business

    What is Equity Financing?

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

    What is Debt Financing?

    When a company needs to pay for something, it can pay with cash, or it may finance the purchase. Financing means that it gets the money from other businesses or sources, in return for obligations. ...
  4. Small Business

    Mezzanine Financing

    Learn about this alternative method of financing companies use to finance expansion.
  5. Investing

    The Difference Between Finance And Economics

    Learn the differences between these closely related disciplines and how they inform and influence each other.
  6. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  7. Small Business

    What Does Corporate Finance Do?

    Corporate finance is the subset of finance that involves how corporations use leverage to fund their operations and capital purchases.
  8. Investing

    What Does Finance Cover?

    Finance is the study of banking, leverage, credit, capital markets, money and investments, along with how they are used by individuals and companies.
  9. Investing

    What Does Negative Shareholder Equity On A Balance Sheet Mean?

    Negative shareholder equity on a company’s balance sheet is a red flag that should prompt potential investors to take a closer look before committing their money.
  10. Small Business

    The Basics Of Financing A Business

    From debt financing to equity financing, there are numerous ways to fund a business startup. But which is the best?
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center