A publicly traded firm just announced that its issuing debt to finance a new project.Which of the following scenarios is most likely true in a market with asymmetric information?
A)The firm's future prospects look good and they are sending a costly signal that indicates they will be able to meet higher debt obligations.
B)The firm has a questionable project and are attempting to increase the attractiveness of the project by raising the WACC via an increase in the level of debt financing.
C)The firm has a poor project but they know debt financing provides an effective tax shield.
D)None of these signals are viable explanations.

Question

Quizplus · Accepted Answer

A) In a market with asymmetric information, when a firm decides to issue debt to finance a new project, it is often interpreted as a positive signal. This is because taking on debt increases the firm's financial obligations in terms of interest and principal repayments. If the firm's management decides to issue debt, it suggests they are confident about the firm's future cash flows and its ability to meet these higher obligations. This act can be seen as a costly signal (since failure to meet debt obligations can lead to financial distress or bankruptcy) that the firm's future prospects are good.

A Publicly Traded Firm Just Announced That Its Issuing Debt