Signalling risk and value: a unifying approach

Abstract

When insiders (management) of a firm have more information than outsiders (investors) then insiders’ desire to sell overpriced securities creates an Adverse Selection problem. To mitigate the problem, the Pecking-Order hypothesis proposes that debt finance should dominates equity finance. But according to the debt rationing literature, debt finance is also prone to the Adverse Selection problem. The paper addresses the puzzle by allowing firms to issue both debt and equity together and by having a general notion of what it is that insiders know more about. We show that safe firms use more equity than risk firms to credibly signal their type to investors. The paper provides a generalization of the existing financial signalling literature and reconciles previously contradictory findings.