Question

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good. True or False?

Answer 1

Answer: False

Explanation: In simple words, signalling theory refers to the business phenomenon which states that an increase of dividend by the management of a company depicts that the future aspects of a company is bright and there will be higher profits in the near future for the investors.

An issue of dividend by the company suggests that they have sufficient equity and are using debt just for cheap source of financing.

Increasing equity in the company who is already getting high dividends can lead to a decrease in return as a small portion of income will be distributed to a larger base.