Screening, Market Signalling, and Capital Structure Theory

Abstract

This paper develops an equilibrium model in which informational asymmetries about the qualities of products offered for sale are resolved through a mechanism which combines the signalling and costly screening approaches. The model is developed in the context of a capital market setting in which bondholders produce costly information about a firm's a priori imperfectly known earnings distribution and use this information in specifying a bond valuation schedule to the firm. Given this schedule, the firm's optimal choices of debt-equity ratio and debt maturity structure subsequently signal to prospective shareholders the relevant parameters of the firm's earnings distribution.OUR OBJECTIVES IN this paper are threefold. First, we discuss an alternative equilibrium mechanism for resolving the informational asymmetry problem in a "lemons" type market in which some agents are a priori better informed than others. This mechanism, recently proposed by Thakor [19], is distinct from and yet integrates the salient features of the screening (see Stiglitz [17] and Viscusi [21]) and signalling (Bhattacharya [41]) paradigms. Second, we demonstrate that the equilibrium notion developed is relevant to the determination of an interior optimal capital structure for a firm in a world of imperfect information. This application of our model involves firms with intertemporally distributed cashflows which vary cross-sectionally and are not necessarily independent and identically distributed (i.i.d.) through time. We use this multiperiod setting to address our third objective, which is to explain a firm's debt maturity decision. Essentially, our argument is that when both the size and timing of a firm's future earnings are indistinguishable ex ante from other firms in the economy, the firm's capital structure and debt maturity choices could simultaneously function as signals of these a priori unknown parameters of its earnings.The market structure we consider is similar to that in Thakor [19].' There are sellers, each of whom offers a variety of products with qualities dependent upon a common set of exogenous attributes unique to the seller, and buyers who are unaware of these attributes. Buyers interested in one of the products offered * Associate Professor of Finance, University of Santa Clara; Associate Professor of Finance, Indiana University; and Assistant Professor of Finance, Pennsylvania State University, respectively. We wish to acknowledge with thanks the helpful suggestions of an anonymous referee. I A feature that distinguishes our model from Thakor's [191 is that we consider vector-valued signals, whereas Thakor [191 looks at scalar signalling. Like the signalling model of Spence [14, 15, 161 and the screening model of Stiglitz [17], our model primarily examines a feasible mechanism that can be deployed to resolve informational asymmetry problems that could otherwise lead to market failure (Akerlof [1]). 1508The Journal of Finance generate costly information about the attributes of the seller and use this information to deter...

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