The theory contends that signal provided by capital structure changes are credible in providing the trend of future cash flows. Actions that increase have been associated with positive equity returns while actions that decrease leverage have been assonated with negative equity reruns, therefore when a firm makes any capital changes it must be mindful of the signal that the proposed transaction will transmit to the market place regarding the firm’s present and future earnings prospects and the intentions of its managers. The theory is based on the assumption of information asymmetry between the management and shareholders.
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