Capital Structure and dividend Irrelevance with Asymmetric Information

The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most recent papers on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We also show that making prices reflect idiosyncratic information more accurately does not make investors better off, thus negating the motivation of many of the signalling models.