According to the signaling theory, when should a firm use debt to finance beyond the normal target capital structure?
A)When the debt/assets ratio is greater than one
B)When marginal tax shelter benefits are equal to marginal bankruptcy-related costs
C)When investors and managers have identical information about the firm's prospects
D)When the firm has favorable prospects
E)When the firm is entirely equity financed

Question

Quizplus · Accepted Answer

According to the signaling theory, a firm should use debt to finance beyond the normal target capital structure when it has favorable prospects. This is because the use of debt signals to investors that the firm is confident in its ability to generate future cash flows and repay its debt obligations. When investors perceive a firm as having favorable prospects, they are more likely to invest in the firm's equity, which can ultimately benefit the firm. However, if a firm has poor prospects and uses debt to finance beyond its target capital structure, it may signal to investors that it is unable to obtain equity financing and may face future financial distress, which can ultimately harm the firm. Therefore, the use of debt to finance beyond the normal target capital structure should be carefully considered and should be based on a firm's prospects.

According to the Signaling Theory, When Should a Firm Use