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The Determination of Financial Structure: The Incentive-Signalling Approach

Stephen A. Ross
The Bell Journal of Economics
Vol. 8, No. 1 (Spring, 1977), pp. 23-40
Published by: RAND Corporation
DOI: 10.2307/3003485
Stable URL: http://www.jstor.org/stable/3003485
Page Count: 18
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The Determination of Financial Structure: The Incentive-Signalling Approach
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Abstract

The Modigliani-Miller theorem on the irrelevancy of financial structure implicitly assumes that the market possesses full information about the activities of firms. If managers possess inside information,however, then the choice of a managerial incentive schedule and of a financial structure signals information to the market, and in competitive equilibrium the inferences drawn from the signals will be validated. One empirical implication of this theory is that in a cross section, the values of firms will rise with leverage, since increasing leverage increases the market's perception of value.

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