Signaling with Capital Structure Revisited

We consider a signaling model with a good and a bad type of firm. The market does a priori not know the firm's type. The firms, which are run by equally qualified managers, can use their debt level to signal their true value to the market. In addition to debt, the manager chooses his effort level, which directly affects the firm's product market returns. The effort choice interacts with the signaling mechanism of debt issue and affects the equilibrium debt level. As a result, it is not always possible to derive the type of firm from its capital structure