Notes on Costless Financial Signalling

Abstract

Although almost a decade has passed since Stiglitz (1974) pointed out that “changes in financial policy may be an important signal for the real prospects of the firm”, there have been relatively few attempts to construct formal models in which financial policy serves as a signal. The two earliest financial signalling models are those of Ross (1977) and of Leland and Pyle (1977). In Ross’ model a particular, exogenously determined, type of managerial compensation contract induces the manager to select a debt ratio for the firm which depends on the distribution of firm earnings. As a result, the manager’s decision reveals to investors the parameter of the probability distribution of firm earnings which is known directly only to him. The model includes an exogenous cost which is imposed on the manager in the event of bankruptcy, and thus would be a dissipative,¹ or costly, signalling model if the probability distribution of earnings had support over the whole real line. In fact, Ross assumes that the probability distribution is uniform and then bankruptcy never actually occurs.

The authors are grateful to Gordon Sick and Sanford Grossman for helpful discussions on an earlier draft of this paper.