Repeated Signaling and Firm Dynamics

Abstract

As an alternative to the pecking order, we develop a dynamic calibratable model where the firm avoids mispricing via signaling. The model is rich, featuring endogenous investment, debt, default, dividends, equity flotations, and share repurchases. In equilibrium, firms with negative private information have negative leverage, issue equity, and overinvest. Firms signal positive information by substituting debt for equity. Default costs induce such firms to underinvest. Model simulations reveal that repeated signaling can account for countercyclical leverage, leverage persistence, volatile procylical investment, and correlation between size and leverage. The model generates other novel predictions. Investment rates are the key predictor of abnormal announcement returns in simulated data, with leverage only predicting returns unconditionally. Firms facing asymmetric information actually exhibit higher mean Q ratios and investment rates. (JEL G32) Three decades have passed since Leland and Pyle (1977) and Ross (1977) developed the signaling theory of corporate finance. Although their work has been extended, signaling models remain static and qualitative, making it impossible for empiricists to assess the theory’s ability to match observed timeseries moments. Furthermore, most signaling models ignore investment. This further hinders empirical testing, and also makes it impossible to assess the impact of signaling on the real economy. The objective of this article is to fill the existing void, and facilitate empirical testing, by developing a dynamic signaling theory of corporate financing and investment. The model is rich in that debt, default, equity flotations, dividends, share repurchases, and investment are all determined endogenously, as is the evolution of net worth.