Strategic Decision Making of the Firm Under Asymmetric Information

Abstract

This paper develops a simple signaling model whereby high valuation firm uses levels of investment, debt and dividends to convey information to the market regarding its valuation. Conditions are determined under which investment, debt and dividends are employed in a separating Nash equilibrium. Unlike many other signaling models where the source of asymmetric information concerns only the mean of the firms' cash flow, our model allows for two sources of asymmetric information: the mean and the variance of the cash flow. This paper finds that the choice of signals depends on the relative importance of these two sources of informational asymmetry. For example, we show that high valued firms signal their values by decreasing their debt if the source of asymmetric information is mainly driven by the variance of the cash flows. This latter result differs from the debt signaling models found in the literature. The findings of this paper are consistent with extensive empirical evidence.

Keywords: Capital Structure, Signaling Model

JEL Classification: D82, G32