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. Small Business

    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.
  2. Small Business

    Explaining Cost Of Capital

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

    Mezzanine Financing

    Learn about this alternative method of financing companies use to finance expansion.
  4. Small Business

    Small Business Financing: Debt Or Equity?

    There are two sources of financing for small businesses: debt and equity financing. This article explains both.
  5. Investing

    How Dividends Affect Stockholders' Equity

    Find out how dividends affect a company's stockholders' equity and how the accounting process changes based on the type of dividend issued.
  6. 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?
  7. Investing

    The Dangers Of Share Dilution

    Share dilution reduces the value of an individual investment and can drastically impact a portfolio.
  8. Investing

    What Dividends Say About Stock Health

    Dividend payments may reveal information about the future prospects of a company.
  9. Investing

    The Difference Between Finance And Economics

    Finance and economics are often taught as separate subjects, but they are interrelated disciplines that influence one another in many ways.
Frequently Asked Questions
  1. What is a good annual return for a mutual fund?

    Learn the key factors that determine if a mutual fund's return is "good" for you and your needs?
  2. How are industrial goods different from consumer goods?

    Understand the difference between industrial goods and consumer goods, and learn the different types of industrial goods ...
  3. What causes inflation, and does anyone gain from it?

    In this article, we will examine the fundamental factors behind inflation, different types of inflation and who benefits ...
  4. What is the difference between a buy-side analyst and a sell-side analyst?

    The main difference between a buy-side analyst and sell-side analyst is the type of firm that employs them and the people ...
Trading Center