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Continuous Signaling Within Partitions: Capital Structure and the FIFO/LIFO Choice

Author

Listed:
  • Patricia J. Hughes

    (University of Southern California)

  • Eduardo S. Schwartz

    (University of California, Los Angeles)

  • Anjan V. Thakor

    (Washington University in St. Louis)

Abstract
This paper considers a setting in which managers have private information about the values of their firms and can communicate it to uninformed investors through the use of two signals: capital structure and inventory accounting method. We show conditions under which a separating equilibrium with debt alone does not exist. The two-signal equilibrium involves a partitioned separation in which the highest quality firms choose FIFO and the lower quality firms choose LIFO, and all firms then distinguish themselves with these two partitions through capital structure choices. The analysis helps to explain the many observed empirical regularities about firms' capital structure choices and LIFO/FIFO choices and, in addition, produces numerous testable predictions about the relation between capital structure and inventory accounting method.

Suggested Citation

  • Patricia J. Hughes & Eduardo S. Schwartz & Anjan V. Thakor, 2004. "Continuous Signaling Within Partitions: Capital Structure and the FIFO/LIFO Choice," Finance 0411054, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0411054
    Note: Type of Document - pdf; pages: 19
    as

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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0411/0411054.pdf
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    References listed on IDEAS

    as
    1. Lindahl, Fw, 1989. "Dynamic Analysis Of Inventory Accounting Choice," Journal of Accounting Research, Wiley Blackwell, vol. 27(2), pages 201-226.
    2. Spence, Michael, 1974. "Competitive and optimal responses to signals: An analysis of efficiency and distribution," Journal of Economic Theory, Elsevier, vol. 7(3), pages 296-332, March.
    3. Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
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    5. Datar, Srikant M. & Feltham, Gerald A. & Hughes, John S., 1991. "The role of audits and audit quality in valuing new issues," Journal of Accounting and Economics, Elsevier, vol. 14(1), pages 3-49, March.
    6. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
    7. Dopuch, N & Pincus, M, 1988. "Evidence On The Choice Of Inventory Accounting Methods - Lifo Versus Fifo," Journal of Accounting Research, Wiley Blackwell, vol. 26(1), pages 28-59.
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    11. Banks, Jeffrey S & Sobel, Joel, 1987. "Equilibrium Selection in Signaling Games," Econometrica, Econometric Society, vol. 55(3), pages 647-661, May.
    12. Zmijewski, Mark E. & Hagerman, Robert L., 1981. "An income strategy approach to the positive theory of accounting standard setting/choice," Journal of Accounting and Economics, Elsevier, vol. 3(2), pages 129-149, August.
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    JEL classification:

    • G - Financial Economics

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