 It is assumed that the creditors, managers and stockholders of a firm have same level of information regarding the firm's state of affairs. And it is also assumed that the securities of a firm are fairly priced in the market. But in real-world firms, these two principles may not hold true. As the managers generally have superior level of information regarding the firm's affairs than the outsiders. That includes also the investors. So we can say that there is existence of some information is symmetry between the managers and the outsiders. How leverage can be used as a credible signal by the manager of a firm, a struggling manager in a firm of financial crisis may try to please investors for the firm. And a good way to please these investors is to launch an investor-relation campaign. Now, an unbiased manager's action must give some credible signals of her knowledge on the firm to the external world. This means that there appear some credibility principle and that principle say that the claims by someone are credible if supported by the actions that may cost much to take if these claims were turned on through. This means that the investors and analysts should be able to verify the claims made by the managers in that particular firm. Now, question rises that how a manager credibly communicate her positive information regarding the firm to the outsiders. One way is to commit the firm to large future debt repayments. This means that managers can use leverage as a credible signal to investors of the firm's growth. For example, its future cash flows. This means that the managers may even unable to provide verifiable sources of these future prospects of the firm or the expected growth rate of the firm. But the investors will interpret additional leverage as a credible signal. This means that there exist a signaling theory of debt behind this phenomena, which says that the use of leverage as a way to signal good information to the investors and that is a central idea of the signaling theory of debt. By adverse selection, we means a market derived that can lead to a market collapse as the buyer cannot easily ascertain true value of the product offered to him for sale. For example, an investor with an offer of 70% streak in a firm's capital may suspect this firm as probably a poorly performing firm. By Lehman principle, we mean that when a seller has private information about value of the goods, but the buyer will discount the price they are willing to pay the seller due to the problem of adverse selection. Now, to understand the promenade of adverse selection and Lehman principle, we assume that we have an all-equity firm with market value of 200 million comprising of 20 million shares of $10 each. The firm's true market value of its 20 million shares as per the management's belief based upon the future prospects is 300 million. The firm has an announced plan to raise $60 million for its new research lab by issuing 6 million new shares at a current share price of $10 each. Now, if the good news comes out, the value of the firm's assets will be like from existing assets of 300 million and 60 million from new labs. The total value of the firm will be equal to 36 million comprising of 26 million shares at a share price of $13.85 each. But if the firm waits for the good news and later go for the equity issue, then the share price will raise to $15 each. This means that now at that particular time in future, the firm will need only 4 million shares to issue to raise the amount of $60 million in equity. This means that at that time, the value of firm's assets would be equal to $360 million at the same. But now this number of outstanding shares would be $24 million and the share price will be $15 each. This means that the managers believe that shares are underpriced at present at a price of $13.550. So they will prefer to wait until after the share price rises to the true value which is $15 each. This means that otherwise due to this adverse election, investors will be willing to pay only a low price for these shares. So what are the implications of these adverse selection for the equity shares? The lemon principle directly implies that the stock price declines on announcement of equity shares. This means that in fact, the investors suspecting this share are overly priced. They are willing to pay lesser amount. Second, the stock price tends to rise to the announcement of an equity issue. This means that issuing equity at time, having the smallest informational advantages over the investors. And third implication is that the firms tend to issue equity when information asymmetry is minimized. For example, such as immediately after the announcements of the firms earnings. So far as the implications for capital structure are concerned, managers perceiving the firms equity being underpriced will prefer to fund investments using retained earnings or debt rather than the equity. And conversely, the managers perceiving the firms equity being overpriced will prefer to fund the investments using new equity rather than the retained earnings of the firm or the debt. This means that there is a picking order hypothesis which states that the managerial behavior of electing to use retained earnings first and issuing the new equity as the last resort. So we have an other view on the capital structure and that is the timing view of capital structure. This timing view of capital structure states that the dependence of financing choice on the manager's belief on the firm's stock price being underpriced or the overpriced by the investors in the market. Now, to understand the picking order of financing alternatives, we have an example. Our firm needs to raise $10 million for one of its new projects and financing options the firm has a one year debt at interest rate of 7% new equity issue. This is perceived by the management underpriced by 5%. The management view on firms level of risk of 6% requirement is that the cost to current shareholders of financing the project out of retained earnings, debt and equity. So we have to decide the better of a choice among these options. If we see the solution, we see that using retained earnings will cost $10 million to the shareholders as the firm will not be able to pay this $10 million as dividend to the shareholders. So far as the debt cost is concerned, it will cost the firm at its present value, which is $10.094 million. And if we go for new equity issue, this will cost to the existing holders by $10.5 million. Now, if we compare the cost associated with the three alternatives, we can see that the final decision comes to the point that retained earnings are the cheapest source of funds followed by debt and finally by the equity.