Debt-equity choice as a signal of earnings profile over time

This paper analyzes debt-equity choice for financing a two-stage investment when a firm's insiders have private information about the firm's expected earnings. When private information is one-dimensional (for example when short-term earnings are common knowledge while long-term earnings are private information) a separating equilibrium does not exist. When private information is two-dimensional a separating equilibrium may exist where firms with a higher rate of earnings growth issue debt and firms with a lower rate of earnings growth issue equity. This provides new insights into the issue of different kinds of securities by different types of firms under asymmetric information as well as the link between debt-equity choice and operating performance. (C) 2006 Board of Trustees of the University of Illinois. All rights reserved.