Digitized by the Internet Archive in 2011 with Funding from Boston Library Consortium Iviember Libraries Working Paper Department of Economics Simultaneous Signaling to the Capital and Product Markets By

This paper analyzes an informed firm's choice of financial structure using what we call a two-audience signaling model ; the choice of a financing contract is observed not only by the capital market, but also by a second interested (but uninformed) party. This second party might be a competing firm or a labor union. A key feature of the model is that the informed firm's gross profit is endogenous, because the second party's action depends on the transaction it observes between the informed firm and the capital market. The main result is that the reasonable capital-market equilibria (i.e., those that satisfy a refinement) maximize the ex-ante expectation of the informed firm's endogenous gross product-market profits. In this sense, the character of capital-market equilibrium is determined by the structure of the product market. An immediate corollary is that (generically ) either all the reasonable equilibria are separating or all the reasonable equilibria are pooling. Indeed, the latter is often the case. This is in distinct contrast to earlier work on the information content of financial structure and to more recent work on refinement in signaling games, both of which focus on separating equilibria. 1 . Introduction Models in which informed managers attempt to signal private information to the capital market have been used to explain a wide variety of corporate financial behaviors, including capital-structure decisions (Ross [1977], Myers and Majluf [1984]), dividend policy (Bhattacharya [1979], Miller and Rock [1985]) and management share ownership (Leland and Pyle [1977]). The appeal of these models is that they account for corporate financial behavior that is otherwise difficult to rationalize, and they are based on the reasonable assumption that a manager has private information about the firm's performance. These models, like most in the finance literature, abstract from the other markets in which the firm operates. Yet, when a firm reveals information to the capital market, it often does so by a publicly observable action (such as a dividend) that reveals information to otherwise uninformed agents in other markets (such as product-market rivals). These agents then condition their behavior on this information, and this affects the profit (gross of financing costs) of the informed firm. When the informed firm's gross profit is endogenously determined in this way, product-market considerations affect the informed firm's decision to reveal information through its financial policy. This payoff endogeneity is important; it is the crucial determinant of equilibrium in our model. It is also a second dimension (in addition to asymmetric information) on which the model departs from the Modigliani-Miller framework: financing costs and gross profits are endogenously determined by financial policy. We capture these ideas by developing a model in which the informed firm signals to two uninformed audiences the capital market and the