Asymmetric Information concerning the Variance of Cash Flows: The Capital Structure Choice

Ivan E Brick, Michael Frierman and Yu Kyung Kim

International Economic Review, 1998, vol. 39, issue 3, 745-61

Abstract: This paper assumes that a higher valued firm is distinguished from its lower valued counterpart by having a cash flow distribution with a lower variance. A separating (sequential) Nash equilibrium signaling model is developed in which firms use the levels of debt and dividends to convey information to the market regarding the variance of their underlying cash flow. In contrast to most, if not all, debt signaling models, the higher quality firm signals its value by issuing new equity (decreasing the leverage) while simultaneously offering cash dividends. Copyright 1998 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Date: 1998
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