Firms raise debt and equity capital to finance a positive net present value project in perfectly competitive capital markets; firm insiders know the function generating the random firm cash flow but potential capital suppliers do not. Taking into account the incentives of insiders to misrepresent their firm type, capital suppliers attempt to design financing mixes of debt and equity that eliminate the adverse incentives of insiders and correctly price securities. Necessary conditions for a costless separating equilibrium are developed to show that the amount of debt used by a firm is monotonically related to its unobservable true value.

This paper is an empirical examination of the relation between firm value and two potential actions by entrepreneurs attempting to signal to investors information about otherwise unobservable firm features. The signals investigated are the proportion of equity ownership retained by entrepreneurs and the dividend policy of the firm; both signals are hypothesized to be positively related to firm value. Using a sample of unseasoned new equity issues, the empirical results are consistent with the entrepreneurial ownership retention hypothesis, but the dividend signaling hypothesis is rejected.