Lecture 3.

Hidden Information (Signaling)

Fabio Castiglionesi
CentER, and Tilburg University

In these notes we analyze the situation where it is the informed party

that moves rst in the contractual relationship, and so she will try to signal
her type to the uninformed party.

1 Spence's Education Model

The rst model to present the framework of the signaling analysis has been
proposed by Spence (1973) in the context of the labor market. Spence's
main idea is that education level acquired before entering the labor market
may act as a signal of worker's future productivity. Spence's model is a case
of pre-contractual signal: The informed principal/worker takes an action to
convey information before signing the contract. Another case is when the
signal is embedded in the contracting phase through the form of the contract
(for example, the decision to issue shares or not by a company).
Let denotes the level of productivity of a worker, which is private infor-
mation. Workers can have only two levels of productivity. The set of types
is then = f H , L g with H > L > 0. The rm, which wants to employ
the workers, has an a priori belief about the worker's type. Let ( i ) 2 [0; 1]
the rm's a priori belief (probability) that it is facing a worker of type i .
Education is costly. If a worker of type i decides to study e years she
incurs a cost given by the function c(e; i ), with c(0; i ) = 0, ce (e; i ) > 0,
ce i (e; i ) < 0, and c i (e; i ) < 0. The last assumption implies that higher
productivity workers incur less cost in education. This is a crucial assump-
tion, and its rationale is that for an higher productivity worker it is less costly
to go to school and acquire education. Moreover, note that education level
does not increase worker's productivity (which is given at the moment the

1
worker is born). Education in this model is a pure waste. Its only role is
to signal worker's productivity, and so to allow workers with high productiv-
ity to distinguish themselves from low productivity ones. Clearly this is an
unrealistic assumption, however it allows to identify precisely the signaling
role of education. When needed, we will assume the functional form ei (with
i = H; L) for the education cost function.
When workers accept a job, they will get a wage w. Workers are willing
to work at any wage w > 0. The utility of the worker of type i is then

ui (w; e) = w c(e; i ).

From the utility function we can draw the indi erence curves for both types of
workers. In order to draw indi erence curves we need to keep utility constant
for both types. To maintain utility constant with di erential changes in e
and w (that is, dw and de) it has to be
" # " #
ui ui
dw + de = 0.
w e

Thus, when e changes by de, the change of w to keep utility constant is given
by
ui = e
dw = de,
ui = w
where the ratio in the second term is the marginal rate of substitution (MRS)
between education and wage. Then at any given pair (w; e) we have

dw ui = e
( )u = = ce (e; i )
de ui = w
which is positive for both types. This result implies that, for both types, a
reduction in e can be accompanied by a reduction in w, and an increase in e
needs to be accompanied by an increase in w.
However, the increases and reductions of the salary are not the same for
both types since ( dw ) is decreasing in i . Indeed ce i (e; i ) < 0. This implies
de u
that type H has a atter indi erence curve than type L . For a given reduc-
tion (increase) of education e, the high type is willing to accept less reduction
(or needs less increase) of salary since for her education is less costly. On the
contrary, the low type is willing to accept more reduction (or needs greater

2
increase) of salary since for her education is more costly. Figure 2.A depicts
an indi erence curve for each of the two types of workers (the arrows indicate
the direction of higher level of utility). The assumption on the cost function
ce i (e; i ) < 0 assures that the two curves cross only once. This resembles
the Spence-Mirrlees condition (also called `single-crossing property') already
seen in the screening model. This condition gives us hope to sort out di erent
types. We restrict attention to the case of one rm and one worker set up.
Assume there is no asymmetric information, that is the productivity of
the worker is observable. In this case the optimal solution is eH = eL = 0
and wi = i . Indeed, the optimal solution is that both types of workers get
zero education (recall, in this model education is a pure waste) and being
paid according to their observed productivity.
When productivity is not observable, the high type worker could nd it
convenient to signal his type to the rm. In this case the signaling game is
made by two stages:

1. The worker chooses the level of education e (to maximize her utility);

2. The wage w is determined (the principal/worker makes a take or leave

it o er).

We solve the game from the second stage. In this stage the outcome is
determined by the agent/ rm's belief about worker's type and how the choice
of e a ects those beliefs. Let ( i je ) the posterior belief of the rm about the
worker productivity. The posterior belief of the rm can be di erent from
its a priori belief after observing the education level of the worker. In the
second stage the equilibrium wage has to be equal to the worker's expected
productivity
w(e) = ( H je ) H + ( L je ) L
where ( H je ) + ( L je ) = 1. This wage is what the rm is willing to
pay (and then to accept) given its updated beliefs about the worker's type.
Figure 2.B shows a possible wage schedule w(e). Clearly, the equilibrium
wage o er resulting from any choice of e must lie in the interval [ L ; H ].
Since this is a game of incomplete information (when the rm decides to
accept or not the worker's o er it does not know the type is facing) we adopt
the perfect Bayesian equilibrium (PBE) as solution concept of the game.
Moreover, we restrict attention only to pure strategy equilibria.

3
De nition. A PBE is a set of pure strategies (eL ; eH ; w ) for the worker's
types and posterior beliefs ( i je ) of the rm such that:

1. All educational levels must maximize worker's utility, that is

ei 2 arg max
e
f ( H je ) H + ( L je ) L c(e; i )g ;

2. Firm's posterior beliefs must be consistent with strategies ei :

When eL 6= eH then if e = eL then ( L je ) = 1, and if e = eH then

( H je ) = 1;

When eL = eH then if e = eL = eH then ( i je ) = ( i );

3. The equilibrium wage must be w (e) = ( H je ) H + ( L je ) L .

Note that this de nition of PBE in no way restricts posterior beliefs

( i je ) when a level of education e di erent from the equilibrium levels (eL
and/or eH ) is chosen in equilibrium. In the case an out-of-equilibrium level
of education is chosen, posterior beliefs can take any value in the interval
[0; 1]. The only thing we can be sure of is that the wage must lie between L
and H . As it will be clear later, the existence of this degree of freedom in
out-of-equilibrium beliefs gives rise to a multiplicity of PBE.
After having chosen the solution concept and determined the wage o er
in the second stage, we are ready to determine also the equilibrium educa-
tion choice of the two types of workers ( rst stage). It is useful to consider
separately two di erent types of equilibria that might arise: separating equi-
libria (in which the two types of workers choose di erent education levels)
and pooling equilibria (in which the two types choose the same education
level).

Separating equilibria. In a separating equilibrium each type of worker

chooses a di erent signal, that is eL 6= eH . Given these di erent choices we
have that posterior beliefs (to be consistent in a PBE) have to be ( L jeL ) =
1 and ( H jeH ) = 1. This implies that the equilibrium wages are w (eH ) =
H and w (eL ) = L . That is, each worker type receives a wage equal to
her productivity. Given this result, low productivity worker will optimally
choose to get zero education. Indeed, since she will get a wage equal to L no

4
matter what is her education level then she will maximize her utility setting
eL = 0.
What about the education level of high productivity worker eH ? Many
education levels for the high type are possible. The rst thing to note is
that in order to have a separating equilibrium the low type cannot have any
incentive to deviate (pretending to be the high type and choosing her same
level of education). In other words, the following incentive compatibility
constraint of the low type has to be satis ed

wL c(0; L) wH c(eH ; L)

that determines a minimum value for eH . If we assume the cost function to

be c(e; i ) = ei , the previous constraint implies
2
eH L H L e1 .

On the other hand, the education level of the high type cannot be too high
otherwise she would prefer to get no education (even if this would result in
being confused with a low type). The incentive compatibility constraint for
the high type has to be satis ed as well

wH c(eH ; H) wL c(0; H)

e
that implies (again assuming c(e; i ) = i
)
2
eH H L H e2 .

The result is that every eH 2 [e1 ; e2 ] can be sustained as a separating PBE.

The separating equilibria can be analyzed graphically. Figure 2.C shows
the possible separating equilibria. First, we draw the indi erence curve of the
low type, which has to pass through her equilibrium level of education (i.e.,
eL = 0) and her wage (i.e., w (eL ) = L ). This is the maximum indi erence
curve (utility) the low type can reach in a separating equilibrium. Second, we
can construct a separating equilibrium. We know that the level of education
e1 is the minimum level that makes the low type not mimicking the education
choice of the high type. So the level of education e1 corresponds to the
intersection between the low type indi erence curve and the wage H paid
to the high type. The indi erence curve of the high type is then drawn

5
passing through one of her possible levels of education (e1 ) and her salary
( H ). Finally, we can draw the wage schedule w (e1 ).
To verify that this is indeed a PBE we note that we are free to let rm
to have any beliefs when the education level is neither 0 nor e1 . We only
must have ( L jeL ) = 1 and ( H jeH ) = 1, and the wage schedule w (e1 )
exactly re ects these beliefs since we have w (0) = L and w (e1 ) = H .
It is then easy to see that, given this wage schedule, both types of workers
are maximizing their utility (indeed for each type the worker's indi erence
curve is at the highest-possible level along the wage schedule w (e1 )). Thus,
strategies feL ; eH ; w (e1 )g and the associated beliefs of the rm constitute
a PBE.
However, this is not the end of the story. First, as we already said, the
PBE does not restrict out-of-equilibrium beliefs. Graphically, this implies
that we do not have any restriction in drawing the wage schedule w (e1 ).
Many wage schedule can arise that support the equilibrium education choices
feL = 0; eH = e1 g. Second, as anticipated, the education choice e1 for the
high type is not the only one. Any education level between e1 and e2 can
be sustained in equilibrium. In gure 2.C it is also shown a possible wage
schedule w (e2 ) that supports the education level e2 . This level of education
can be sustained because the high type can fear that if she chooses a lower
level than the one prescribed in equilibrium (i.e., e2 ) the rm can believe
that she is not the high type, and would pay her less than H (according
to the wage schedule w (e2 )). The out-of-equilibrium beliefs are those that
make the rm pay less than H , but these beliefs can be maintained because
in equilibrium they are never discon rmed. Accordingly, if the high type is
expecting e2 to be the equilibrium level of education then she has to get it.
The result is that a continuum of separating PBE can be sustained.

Pooling equilibria. In a pooling equilibrium both types choose the same

education level (signal) in equilibrium, that is eL = eH = e. In this case
posterior beliefs coincide with prior beliefs since the education choice it is not
informative to update beliefs. So we have ( H je ) = ( H ) and ( L je ) =
( L ), with ( H ) + ( L ) = 1. The equilibrium wage is then
w (e) = ( H) H + ( L) L = E[ ]
where E[ ] is the average worker's productivity. The level of education that
can arise in a pooling equilibrium is determined by the incentive compatibility

6
constraint of the low type. She has to get at least the utility she would get
without studying with a salary equal to L . That is,

w (e) c(e; L) w (0) c(0; L)

e
which implies (assuming c(e; i ) = i
)

e 2
( H) H + ( L) L L =) 0 e ( H )[ L H L] ep .
L

Also the pooling equilibria can be analyzed graphically. Figure 2.D shows
the possible pooling equilibria. First, we can draw the indi erence curve of
the low type, which has to pass through her level of education (i.e., one of the
values that e can take) and the average wage (i.e., w (e) = E[ ]). In partic-
ular, in Figure 2.D is depicted the lowest indi erence curve (utility) that the
low type can reach in a pooling equilibrium. This indi erence curve passes
through the highest-possible level of education (i.e., ep ) and the average wage
(i.e., E[ ]). Note that this indi erence curve passes also through the point
(0; L ) since the low type is indi erent at that level of utility between (0; L )
and (ep ; E( )). Higher indi erence curves can be drawn for each possible
value of e. The indi erence curve of the high type is then drawn passing
through the same point (ep ; E[ ]). Finally, we can draw the wage schedule
w (ep ) that sustains the equilibrium education level ep .
To verify that this is indeed a PBE, note that the wage schedule w (ep ) is
consistent with Bayesian updating on the equilibrium path because it gives
a wage of E( ) when education level ep is observed. Finally, both types of
workers are maximizing their utility (for each type the worker's indi erence
curve is at the highest-possible level along the wage schedule w (ep )).
Like in the case of separating equilibria, we have a continuum of pool-
ing equilibria. First, the PBE does not restrict out-of-equilibrium beliefs.
Graphically, this implies that we do not have any restriction in drawing the
wage schedule w (ep ). Second, the education choice ep is not the only one.
Any education level 0 e ep can be supported in equilibrium (similarly
to the education level ep analyzed before). A possible wage schedule w (ep1 )
that supports the education level ep1 is also shown in gure 2.D. Any level of
education can be sustained in a pooling equilibrium because both types can
fear that if they choose a lower level than the one prescribed in equilibrium
(i.e., ep or ep1 ) the rm could believe that they are not the "average" type,

7
and would pay them less than E( ) (according to the wage schedule w (ep )
or w (ep1 ). The out-of-equilibrium beliefs are those that make the rm pay
less than E( ), but these beliefs can be maintained because in equilibrium
they are never discon rmed. Accordingly, if both types are expecting ep to
be the equilibrium level of education then they have to get it. The result is
that a continuum of pooling PBE can be sustained.

Pareto Ranking. Even if we have a multiplicity of equilibria, we can rank

them both among the separating and the pooling equilibria.
Consider the separating equilibria. In this case the rm earns zero rent,
and the low type worker earns the salary L . However, the high type worker
does strictly better in the equilibrium where she gets less education (that
is, when eH = e1 ). Graphically (Figure 2.C) the highest indi erence curve
for the high type is reached when the equilibrium level of education is e1 .
Thus, the separating equilibrium with eH = e1 Pareto dominates all the
other separating equilibria. It is useful to repeat that the Pareto-dominated
equilibria are sustained because the high productivity worker fears being
confused with the low ability worker.
Consider the pooling equilibria. Also in this case the rm earns zero
rent. However, the pooling equilibrium where the education level is e = 0
clearly Pareto dominates all the other pooling equilibria (where e > 0). In a
pooling equilibrium the wage is equal to the productivity average E( ), then
the maximum utility for both types is obtained when they get no education.
Graphically (Figure 2.D) this is evident since when e = 0 and w = E( ) both
types reach the highest-possible indi erence curves (not drawn). Again, the
Pareto-dominated pooling equilibria are sustained by worker's fear that a
deviation will induce the rm to have an unfavorable impression on her type.

Re nement. The multiplicity of equilibria is amazing. There exist a con-

tinuum of separating equilibria indexed by eH 2 [e1 ; e2 ] and a continuum
of pooling equilibria indexed by e 2 [0; ep ]. If we want to have precise pre-
dictions from the theory this result is not good. If we want the theory to
be more powerful in making predictions, we need to restrict the number of
possible equilibria.
This multiplicity of equilibria stems from the fact that out-of-equilibrium
beliefs are not constrained by the PBE. The equilibrium salary has to be

8
determined only for education levels that are chosen in equilibrium, and this
translates in the freedom to draw the equilibrium wage schedule away from
the equilibrium level of education. The only way to reduce the number of
equilibria is then to restrict out-of-equilibrium beliefs (and consequently the
wage schedule). Clearly, restrictions do not come without costs. The cost
of having more precise predictions, is to add extra rationality to the agents
involved in the model.
The most popular re nement is the intuitive criterion by Cho and Kreps.
The intuition behind their re nement is that some deviations from the equi-
librium action could never be in the interest of any of the two types. Beliefs,
conditional on out-of-equilibrium actions, therefore should re ect the fact
that these actions are more likely to be chosen by one type instead of the
other. Formally, in Spence's education model, the intuitive criterion can be
stated as follows.

De nition. Let ui = wi (ei ) c(ei ; i ) the equilibrium utility of type i. Then,

when an out-of-equilibrium education choice e is observed (i.e., e 6= eH ,
e 6= eL , e 6= e) the following applies: Whenever H c(e; L ) < uL and
H c(e; H ) uH then ( L je ) = 0.

The re nement states that when a deviation is dominated for one type of
the player but not for the other type, then the deviation cannot be attributed
to the type for which the deviation is dominated. By dominated, one means
that the player is getting a worse payo (utility) than her equilibrium payo
for any belief of the uninformed party following the deviation. Here the most
favorable belief after a deviation is ( H je ) = 1 implying a wage of H . Then
a deviation is dominated for the low type but not for the high type if and
only if H c(e; L ) < uL and H c(e; H ) uH . In this case the intuitive
criterion states that the belief should be ( L je ) = 0.
Applying this criterion to the pooling equilibria they disappear altogether.
Indeed, any deviation from the equilibrium means that an education level
higher than ep is chosen. The only type that has a pro table deviation
choosing an education level higher than ep is the high type. For the low type,
any education level higher than ep is dominated by zero education (remember
her incentive compatibility constraint). Then after observing a deviation
from the equilibrium education level, the rm should assign probability zero
to the low type. This implies that the high type has an incentive to increase

9
her education level above ep , and o ering a wage of H to the rm. This o er
will be accepted since the rm is sure to face an high type worker.
Applying the same criterion to the separating equilibria only one survive:
The `least-cost' separating equilibrium in which eL = 0 and eH = e1 . Indeed,
any education e 2 [e1 ; e2 ] is dominated for the low type since she would pre-
fer zero education (again, remember her incentive compatibility constraint).
That is, a low type worker cannot be better o choosing such an education
level than she is getting with zero education regardless of what the rm be-
lieves about her. Then, according to the Cho-Kreps criterion, the belief of
the rm has to be ( L je ) = 0. At this point, since the rm is sure to face
an high type worker for every e 2 [e1 ; e2 ], the salary should be equal to H
observing any education level belonging to that range. The high type then
will choose the lowest education level possible in that range (to maximize her
utility) which is e1 . The least cost separating equilibrium is shown in Figure
2.E.

2 Application: Signaling Approach to Capital

Structure
The main result on capital structure is the well known Modigliani-Miller
(MM) theorem. The traditional (pre-MM) theory of the optimal capital
structure went by and large as follows. In the economy there are di erent
types of investors, with di erent risk attitudes. Those who are more risk
averse prefer securities with a concave return stream, such as debt, while
those who are more risk-loving prefer securities with a convex return stream,
such as equity. A rm deciding to use a single nancing instrument, e.g.
equity, is losing opportunities for cheap nancing since it is not using an
important source of capital given by risk-averse investors. The optimal choice
of the debt-equity ratio can therefore be determined looking at the relative
strength of the two di erent `clienteles' existing in capital market.
Modigliani and Miller said that, intuitive as it may be, this argument is
entirely wrong. This argument would be true if the rm is the only entity that
issues securities. The main intuition behind their argument is that investors
can undo (or do) any nancial choice made by the rm through appropriate
changes in their portfolios. The nancial choices of rms are therefore of

10
no concern to investors. Arbitrage argument drives the indi erence result of
the Modigliani-Miller propositions. The assumptions under which the MM
theorem holds are the following: capital markets are perfectly competitive,
information is symmetric, no transaction costs, no (distortionary) taxes and
no bankruptcy costs.
Since the capital structure appears to be important, nancial economists
moved to analyze models in which one or more of the assumptions under
which the MM theorem holds are not valid. The `classical' models of the
capital structure developed in the Sixties and Seventies focused on the con-
sequences of removing the assumptions of no distortionary taxes (or, more
precisely, identical scal treatment of debt and equity) and no cost of bank-
ruptcy.
Theories of the capital structure developed in the Seventies and the Eight-
ies emphasize strategic reasons for the choice of debt or equity. Three classes
of models have emerged in the literature:

'Signaling' models, in which the management has some private infor-

mation on the value of the rm and the choice of the capital structure
transmits information.

`Moral hazard' models, in which the capital structure has the role of
providing the management with incentives for maximizing the value of
the rm.

`Corporate control' models where the capital structure determines how

control is passed from one managerial group to another.

In the following sections we will focus on the rst class of models.

2.1 The Myers{Majluf Model

Consider a simple two period model. At period 0 there is uncertainty about
the value that the rm will take at time 1. In particular, the current assets
of the rm will take value:
(
H with probability q
v1 =
L with probability 1 q

11
Furthermore, the rm can implement an investment project with positive
NPV. To keep things simple, assume that there is no uncertainty about such
investment and that the rate of interest is zero. The project requires an
amount I of cash today and it generates A > I tomorrow. We will denote
the NPV N = A I > 0. We will assume that:

1. The project has to be nanced through the issue of new shares.

2. The managers know at time zero the value v1 and they act in order to
maximize the value of the shares in the hands of initial shareholders.
3. Everybody is risk neutral.
4. The amounts A; N and I are common knowledge.

Symmetric information. In order to better understand the model, it

is useful to look rst at the case of symmetric information. When managers
don't know v1 at time zero, then it is obvious that the investment project
should be implemented. The value of the rm before the investment project
is:
V0 = qH + (1 q) L;
and the value after the investment will be:
V00 = qH + (1 q) L + A:
In order to nance the investment, the proportion of new equity to be
issued must satisfy:
V00 = I:
Given that (1 ) is the proportion of shares in hand of initial shareholders,
the wealth going to them is (1 ) V00 : This value turns out to be greater
than the initial value:
(1 ) V00 = qH + (1 q) L + A V00 = V0 + N > V0 ;
where we have used V00 = I and A I = N . Thus, old shareholders capture
entirely the NPV of the investment project. Under symmetric information
there is then a pooling equilibrium since the project is implemented indepen-
dent of the rm's type. This result looks nice, but with private information
things change.

12
 Asymmetric information. Let us rst see under what conditions the
investment project is always implemented. If the management always asks
for money in the presence of a pro table investment project then the issue of
new shares does not reveal any information about the value of the rm (this is
a pooling equilibrium of a signaling game). Therefore, the number of shares
to be issued is still obtained solving V00 = I, where V00 = qH + (1 q) L + A.
Let us now check under what conditions it is optimal for the management
to implement the new project in all cases. Suppose rst that the managers
know that the rm is L. Then undertaking the project is convenient if the
value of initial shareholders, when implementing the project, is greater than
the value of not implementing the project:
A
(1 ) (L + A) > L =) > :
L+A
This is always satis ed, since:
I A
= < :
qH + (1 q) L + A L+A
As a consequence, a low-type rm always implements the project. Suppose
next that the true value is H. In this case the condition is:
A
(1 ) (H + A) > H =) > :
H +A
This is not always satis ed. The condition is:

A (H + A) > 0 =) N> (1 q) (H L) ; (1)

where we have used (H + A) = ((qH + (1 q) L + A) + (1 q) (H L))

and (qH + (1 q) L + A) = I.
When condition (1) is satis ed then a pooling equilibrium arises, in which
both types of the rm will undertake the project. The condition is satis ed
when N is su ciently large (big gains from the investment project), H L is
low or q is high (asymmetry not very important). What is happening here is
that the shares are undervalued by the market. The true value is H, but the
market value is qH +(1 q) L. This raises the cost for the rm to nance the
new project via equity. Old shareholders are giving up (H + A) and receive
only (qH + (1 q) L + A). This implies that high type rm should issue an

13
amount of shares I=(H + A), which is smaller than the amount that investors
are willing to buy, i.e. I= (qH + (1 q) L + A) : Note that if q = 1, namely
investors were certain that rm is of high type, then investors would accept
the right amount of shares. On the other hand, in a pooling equilibrium there
is no way to convince investors that the rm is of the high type. The larger
equity stake required in a pooling equilibrium is expensive for the high-type
rm, perhaps so expensive as to make the high-type rm forego the project.
For this reason, the high-type rm would follow the low-type rm in taking
the project only if asymmetric information is not important or the gains from
the project are particularly high.
Observe further that pooling equilibria in which both types do not invest
are not possible, since the low type always wants to invest, no matter what
beliefs this may cause.
When condition (1) is not satis ed then only separating equilibria are
possible. A separating equilibrium always exists, but what kind of separating
equilibria are possible? First, it cannot be the case that only rms with value
H issue shares. This would imply that investors are prepared to buy shares
at value (H + A). But then, a rm of type L would be better o pretending
to be of type H and nancing the project selling overvalued equity.
Thus, the only separating equilibrium occurs when rm L issues and
invests while rm H does not. Under what conditions can this be an equi-
librium? Let be the proportion of shares issued by the low-type rm in
a separating equilibrium (i.e., when only the low-type issues equity). First,
observe that in a separating equilibrium the share to be sold must satisfy:

(L + A) = I: (2)

This equity issue is convenient for rm L, since shares are priced at the correct
value. In fact, (1 ) (L + A) > L is satis ed, given that (1 ) (L + A) =
L+A (L + A) = L + A I = L + N > L:
Let us check what is optimal for H: The (necessary) condition to have a
separating equilibrium is:

(1 ) (H + A) H =) N (H L) ;

where (H + A) = (H + A L + L) and (2) have been used. We there-

fore reach the following conclusions:

14
 When N < (1 q) (H L) then only separating equilibria are pos-
sible.

When (1 q) (H L) N (H L) then both pooling and

separating equilibria are possible.

When N > (H L) then only pooling equilibria are possible.

I I
Here = qH+(1 q)L+A
and = L+A
, then < (unless q = 0).

Empirical implication. The empirical implication of the model is that

the value of the shares never increases after a new issue. When the separating
equilibrium regime prevails then the stock price decreases, because the in-
vestors recognize that the low-type rm has issued equity, while in the pooling
equilibrium the stock price remains the same. In fact, in a separating equi-
librium the rm market value (current shares) in t = 0 is qH + (1 q)(L + N )
re ecting prior beliefs on types and the equilibrium behavior of the rm. Af-
ter announcing an issue, type is L then the rm's value will be L + N . Now
qH + (1 q)(L + N ) > L + N is always satis ed since it can be written as
H L > N , which is always true because in a separating equilibrium neces-
sarely N (H L): On the other hand, in a pooling equilibrium the rm
market value at t = 0 is q(H + N ) + (1 q)(L + N ). After announcing an
issue, investors do not know the type so the value will be qH + (1 q)L + N .
It is easy to check that the two expressions are the same.
In case equity is useless as signal, the high-type rm has to look for other
nancial tools in order to transmit the correct information to the market.
The forces in this model push the rm toward other sources of funds.
Another important observation is that the separating equilibrium is inef-
cient, since type H rms do not implement positive NPV projects. Invest-
ment is ine ciently low: the new project is certain to be pro table, but the
H type foregoes the investment.

2.1.1 Alternatives Sources of Funds

Internal funds. If the rm had a su cient amount of cash S > I from
retained earnings to be used to nance the project then the rm would never
issue equity and it would always internally nance investment. This provides

15
a rationale for the widespread use of retained earnings as the main source of
nancing.
What happens if S < I so that external nancing is still necessary?
Consider again the case of symmetric information. The value of the rm
when no investment is done is:

V0 = qH + (1 q) L + S;

while in the presence of investment we have:

V00 = qH + (1 q) L + A:

In order to nance the investment, new shares must be a fraction of the

total value of the rm such that:
I S
V00 = I S =) =
qH + (1 q) L + A

The condition for a pooling equilibrium is analogous to the one we had before,
that is:
N > (1 q) (H L) :
Notice however that < . Then, it is more likely to have pooling equi-
librium. As a matter of fact, decreases linearly in S; and it is zero for
S = I:
An analogous reasoning applies to the separating equilibrium. Again, it
is clear that the low value rms want to issue equity. The amount to be
raised is:
I S I
= < = :
L+A L+A
The condition for type H to be better o not nancing the project is:

(1 ) (H + A) < H + S ) N< (H L) :

That is, the condition for the separating equilibrium is less likely to be satis-
ed. The conclusion is that internal funds ease the asymmetric information
problem and help the rm to implement e cient investment projects.

16
 Debt. Up to now we have assumed that the only source of outside
nancing by the rm is equity. It is not di cult to see that, if the rm can
issue riskless debt then asymmetric information does not create problems,
and e ciency is achieved. The reason is that with riskless debt the payo to
be given to external investors is xed, and it does not depend on the `true'
value of the shares. Suppose that the rms can o er riskless debt as well
as equity. Suppose the investors accept the debt contract D. The low-type
rm's payo is L + A D and the high-type rm's payo is H + A D. The
payo of the investors is clearly D. Since L > 0, there is always a pooling
equilibrium: both types o er the debt contract D = I, which the investors
accept. Ine ciencies disappear, rms (of all types) never pass up a positive
NPV investment. Note that if L < 0 such that L + A < D then investors
would not accept the contract since the low-type rm cannot repay the debt.
If debt is risky (as in the real world), then problems similar to the ones
we have seen with equity reappear, since the nal value of debt will depend
on the value of the assets. It is clear however that in this case asymmetric
information has a smaller impact, since the value of debt is less sensitive
than equity to the value of the rm's assets. Even if rms can pass up some
investments with positive NPV, the average loss is less with debt than with
equity nancing.

Conclusion. This result has generated the so-called `pecking order' the-
ory of nancing. When there is asymmetric information, rms prefer to use
internal funds, since this source of nancing does not su er from asymmetry
(by de nition, it is always `fairly priced'). If internal funds are insu cient
then rms turn to debt. Only when the debt capacity is insu cient to nance
the project the rm decides to issue equity.

2.2 Other Signaling Devices

The Myers-Majluf model has been very popular and it has helped to clarify a
number of issues. It provides a sensible explanation of the empirical regularity
that new share issues on average lower the value of the rm.
However, the model relies heavily on a number of restrictive assumptions.
Perhaps the most important one is that rms do not have any other way to
credibly communicate their private information than issuing equity. When

17
we consider a richer set of possible actions, the neat results obtained by Myers
& Majluf tend to disappear.

2.2.1 Signaling through Repurchases

Brennan and Kraus (1987) observe that the rm can issue contemporane-
ously debt and equity, and can in fact choose some of these issues to be
negative (i.e. repurchases). This improves the signaling possibilities of rms,
so that e cient equilibria become possible in many cases. In particular, the
combination of equity issuance and retirement of debt is often su cient to
generate e cient equilibria.

An example. Assume risk neutrality and zero interest rate. The rm

has assets in place that in the next period will be worth either 100 with
probability 0:5 or 140 with probability 0:5. As a consequence, the current
value of the rm is 120. The rm has debt with a face value of D = 100,
and 40 shares of equity outstanding. Therefore, debt is riskless and has value
100, while equity has value of E = 20 and each share is worth 0:5.
The rm has the opportunity to invest in a new project. The investment
project at a cost of 10 will produce a stochastic outcome tomorrow. The
probability distribution over the outcome depends on the type of the rm,
which is private information to the rm. If the rm is of type A and the
investment is implemented, the assets of the rm will have value 100 with
probability 0:5 and 200 with probability 0:5. Then the value of the type
A rm is 150. If the rm is of type B the assets will have value 80 with
probability 0:5 and 195 with probability 0:5. The value of the rm in this
case is then 137:5. Notice that the investment has positive NPV in both
cases. In fact, when the project is undertaken by the type A rm it has a
N P V = 150 120 10 = 20; and when the project is undertaken by the type
B rm it has a N P V = 137:5 120 10 = 7:5. As a consequence, e ciency
requires that it be implemented irrespective of the type of the rm.
Consider that the rm has only equity in order to raise capital to nance
the project. In this case, there is a pooling equilibrium in which the rm
always issues shares to nance the investment. The objective of the rm is
to maximize the value of old shareholders (as in Myers-Majluf), subject to
the constraint that enough money is raised to nance the investment.

18
 Let p be the prior probability of type A and (1 p) the prior probability of
type B. If the investment is nanced issuing equity then the value of equity
after the investment is equal to:
1 1 1 1 5 95
p (200 100) + (100 100) + (1 p) 0 + (195 100) = p + :
2 2 2 2 2 2
The fraction of shares to be sold is therefore equal to:
10
= 5 ;
2
p + 95
2

otherwise there is not enough money to nance the investment.

A rm of type A is willing to nance the project with equity if:
20 < (1 ) 50;
where 20 is the value of the shares without the investment and 50 is the
full-information value of the equity (the value of debt is constant at 100).
This is satis ed if:
3
< :
5
Given the previous expression for ; this is equivalent to:
10 3
5 95 < ;
2
p + 2 5
which is satis ed for each p 2 [0; 1].
A rm of type B is willing to nance the project if:
95 11
20 < (1 ) ) < :
2 19
Using again the expression for we have:
10 11
< ;
5p + 95 19
which again is always satis ed for p 2 [0; 1].
Suppose now that the rm is not constrained in issuing only equity in order
to nance the investment. In particular, we allow the rms to issue equity
and retire debt. In this case, it is possible to nd a separating equilibrium,
which is as follows:

19
 Firm A buys back the debt at 100, and raises the 110 to pay for this and
the 10 of the investment issuing 110 new shares at the full information
price of 1 each;
32
Firm B raises the 10 of the project by issuing 3
= 10:67 new shares
at their full information price of 0:9375.
150
In the rst case, the full information price (pf in ) is easily given by 40+110 :
f in
In the second case, the p and the amount of new shares (N S) issued come
from the system:
47:5
= pf in
40 + N S
pf in (N S) = 10:

Notice that the full information value of the original equity for type A rm
is 40. On the other hand, the full information value of the original equity for
40
type B rm is [ 40+10:67 ] 47:5 = 37:5: In both cases the securities are fairly
priced and the rms are able to nance the investment.
We have to check that no type would want to deviate. Consider rst rm
A. By issuing 10; 67 shares at a price of 0:9375 the original shareholders end
40
up with a fraction 40+10:67 = 0:79 of the equity. The true value of the equity
is 50, so that the value to the original shareholder is 0:79 50 = 39:47 < 40
(the value in the original equity). Therefore, rm A does not deviate. As
for rm B, by adopting the strategy of rm A; the original shareholders will
40 40
own 150 of the equity, which will be worth 150 137:5 = 36:67 < 37:5. So,
again, type B will not deviate.
This example, in which the rm repurchases debt when it is of type A,
is consistent with the empirical observation that rms that use part of their
equity to retire debt have higher returns than rms that use the whole equity
for capital expenditure. The retirement of debt can signal higher returs on
the project (returns of type A rm dominate those of type B rm). Then
a rm can sometimes costlessly signal its type by an appropriate choice of
nancing. The intuition for Brennan and Kraus' result is as follows. Type
B debt is less valuable because it can default (with probability 1=2 it will
get only 80 after the investment). Therefore type A rm can signal its type
by repurchasing some (or all) of its debt at its full information value: this
action is costless for type A rm, but is costly for type B rm. If the cost

20
di erencial is large enough (as in the example), it outweights the gain from
mimicking and a separating equilibrium will obtain.

General Analysis Separating equilibria exist in more general situations.

Assume risk neutrality and zero interest rate. The rm needs an amount K
to nance an investment project having positive NPV (for each type).
The probability distribution over the total value of the assets when the
investment is enacted is as follows:
With probability the value is X.
With probability 1 the value is uniformly distributed over the in-
terval [t; t + d], where t is the type of the rm and t + d X for each
possible t.
Initially the rm has debt with face value B0 , and we assume that t B0
t + d for each t, so that debt is not riskless. The value of existing debt for a
rm of type t is given by:
Z t+d
1
VB0 (t) = B0 + min fB0 ; xg dx =
d t
Z B0 Z t+d
1 1
= B0 + xdx + B0 dx =
d t d B0
1 1 2 1 1 2 1 1
= B0 + B t + B0 (t + d) B02 =
d 2 0 d 2 d d
1
= B0 (B0 t)2 :
2d
Attention is restricted to nancing with bonds and equity. This implies that
a nancing strategy can be described by two numbers, (the percentage of
the rm going to new investors) and B1 (the face value of debt remaining
after the nancing).
We want to compute the value of a nancing strategy ( ; B1 ) when the
type t of the rm is known. We can assume without loss of generality that
B1 X, since X is the highest possible value of the rm and no debt with face
value higher than X can be repaid. Suppose rst t B1 , so that bankruptcy
occurs with positive probability. Then, using the same calculations as for
B0 , we obtain:
1
VB1 (t) = B1 (B1 t)2 :
2d

21
The value of equity when there is debt with face value B1 is:
Z t+d
1
VE (t) = (X B1 ) + max fx B1 ; 0g dx =
d t
Z t+d
1
= (X B1 ) + (x B1 ) dx =
d B1
1
= (X B1 ) + (t + d B1 )2 :
2d
Therefore, the total value of the nancing operation (issuing shares for a
proportion , retiring debt with face value B0 and issuing debt with face
value B1 ) is:

V ( ; B1 ; t) = VE (t) + VB1 (t) VB0 (t) =

1
= (X B1 ) + (t + d B1 )2
2d
1
+B1 B0 + ((B0 B1 ) (B0 2t + B1 )) :
2d
If the face value of new debt is B1 < t then the new debt is riskless, and has
value B1 . Equity has value:
Z t+d
1
VE (t) = (X B1 ) + (x B1 ) dx =
d !t
d
= X + (1 ) t+ B1
2
so that the total value of nancing in this case is:
! !
d
V ( ; B1 ; t) = X + (1 ) t+ B1 + B1
2
1
B0 + (B0 t)2 :
2d
We have now to nd out when a separating equilibrium exists. In a separating
equilibrium type t selects a given nancing strategy ( (t) ; B1 (t)) such that:

The investment is nanced, that is for each type t we have:

V ( (t) ; B (t) ; t) K:

22
 The incentive compatibility condition is satis ed, that is for each t and
tb 6= t we have:

V ( (t) ; B (t) ; t) V tb ; B tb ; t :

Brennan and Kraus (1987, Theorem 1) show that incentive compatibility is

equivalent to the condition that, whenever ( ; B1 ) is chosen by type t, then
t is the `worst type' from the point of view of the market, that is the value
of V ( ; B1 ; t) is minimized with respect to t. This provides the conditions:

dV
( ; B; t) = 0;
dt
d2 V
0:
d2 t
Furthermore we have:
V ( ; B; t) = K:
The two equations can be used to nd and B as a function of t.

23
 Figure 2.A

w(ễ)
High Type

Low Type

ễ e

Figure 2.B

θH

w(e)

θL

e
 Figure 2.C

Low Type

High Type

θH

w*(e*2)
θL
w*(e*1)

eL*=0 e*1 e*2 e

Figure 2.D

w*(ep1) Low Type

w

θH

High Type

E(θ)

w*(ep)
θL

0 ep1 ep e
 Figure 2.E

θH

w*(e*1)

θL

0 e*1 e