Asymmetric information concerning the variance of cash flows: The capital structure choice

This paper assumes that a higher valued firm is distinguished from its lower valued counterpart by having a cash Bow 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 Bow. 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.