The Role of Capital Expenditures in Signalling Firm Value
This paper analyzes the case of an entrepreneur who is the sole initial owner of a firm and who has private information as to the firm's true value. It is shown here that it is possible for the entrepreneur's chosen level of capital expenditures for the firm's production process to perfectly signal his private information, with the market's assessment of his firm's value positive function of the expenditure level. The assessment is also demonstrated to be affected by the number of shares that the entrepreneur retains in the firm. In this sense it can be said that the investment and entrepreneurial shareholding level jointly signal the value of the firm, with investment serving as the "true" signal. Among other results it is shown, in contrast to a conclusion of a study by Leland and Pyle, that in this equilibrium, with shareholdings and investment jointly serving as signals, the number of shares retained by the entrepreneur need not be positively correlated with the favorableness of his information.