According to the signaling theory to explain differences in firms' capital structures, if a firm raises new capital by issuing debt rather than by issuing stock, it is a signal that the firm has very good future prospects.

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According to the signaling theory, if a firm raises new capital by issuing debt, it is a signal that the firm is confident in its ability to generate future profits and that the risk of default is low. This is because taking on debt creates a contractual obligation to make regular interest and principal payments, which can only be met if the firm anticipates steady cash flows in the future. Therefore, choosing debt over equity can be interpreted as a positive signal about the firm's future prospects.

According to the Signaling Theory to Explain Differences in Firms