The Determination of Financial Structure: The Incentive-Signalling Approach

The Modigliani-Miller theorem on the irrelevancy of financial structure implicitly assumes that the market possesses full information about the activities of firms. If managers possess inside information, however, then the choice of a managerial incentive schedule and of a financial structure signals information to the market, and in competitive equilibrium the inferences drawn from the signals will be validated. One empirical implication of this theory is that in a cross section, the values of firms will rise with leverage, since increasing leverage increases the market's perception of value.