Signaling Theory

Institute of Southern Punjab. Multan.

Subject: Submitted To:

“Strategic Finance” Sir. Dr.Allah Bakhsh

Submitted By: Kazmi Roll # 27

Syed Sibtul Hassan Asia khan Roll # 37 Siama batool Roll # 29 Shehla majeed Roll # 28 Sehar Roll # 26

Class:

Topic of Assignment:

Date of Submission:

MS (Business Administration)

“Signaling Theory”

13-11-2012

1.

Signaling Theory

Executive Summary Signaling theory is basically the signals created by the company and received by the investors. These signals can be both positive and negative. The pooling Equilibrium and the separation equilibrium in which the investor can easily separate both good quality and bad quality firms. The Debt and Equity signaling by the company in which the investor can easily judge the financial position of the company. Signaling theory states that changes in dividend policy convey information about changes in future cash flows. Dividend signaling suggests a positive relation between asymmetry and dividend policy. In other words, the higher the asymmetric information level, the higher is the sensitivity of the dividend to future prospects of the firm. Another strand of literature suggests that corporate risk management alleviates information asymmetry problems and hence positively affects the firm value. Information asymmetry between managers and outside investors is one of the key market imperfections that makes hedging potentially benefit. In this assignment we exploit the documented interaction between the level of information asymmetry and the dividend policy, along with its interaction with corporate risk management. We argue that risk management alleviates the asymmetric information problem, which is a main determinant of dividend policy.

Signal: A signal is real financial decision, taken deliberately (e.g. Dividend pay-out) and which may have negative financial consequences for the decision-maker if the decision turns out to be wrong. See also signaling theory. Signaling theory: Signaling theory was developed in both economics and finance literature to explicitly account for the fact that corporate insiders ( Officers and Directors) generally are much better informed about the current workings and future prospects of the firm then are outside investors. In the presence of this asymmetry information it is very difficult for the investor to differentiate between the high – quality firms and the low quality firms. Signaling theory is based on the assumption that information is not equally available to all parties at the same time, and that information asymmetry is the rule. Information asymmetries can result in very low valuations or a sub optimum investment policy. Signaling theory states that corporate financial decisions are signals sent by the company's managers to investors and that signal can be positive and negative. These signals are the cornerstone of financial communications policy.

Pooling Equilibrium When both good and bad firms claim to have excellent growth and profitability prospects then the investor place both good and bad quality high and low quality firms at the same level. So the Pooling Equilibrium will create in which both high and low quality firms are at the same valuation pool.

Separation Equilibrium or Stable Equilibrium

Separation Equilibrium is made when a difference is created between high and low quality firms. This difference creates when high quality firms employ a signal that would be costly but affordable for the firm but that would be expensive for low quality firms. The best example of a potentially useful signal is the payment of large cash dividends. This strategy would be expensive for the high – quality firm because the firm would have to reduce its planned level of capital expenditure but still the firm would remain sufficiently profitable to both finance a high level of Investment and pay out cash investors on the other hand this signal would be so costly for the low quality firms.

In this case the investor would easily differentiate between high quality and low quality firms and the investor would trust and invest in that firm which is promising and paying high amount of dividends so in this case a separation equilibrium will create in the market and the investor would easily differentiate between a good firm and a bad firm this is also called as Stable Equilibrium.

Signal Test

A signal must pass two tests to be useful in the market characterized by asymmetric information.

First is it must be costly to the signaling firm in the sense that the company would not otherwise choose to adopt it except to convey information to the investors or to give the positive signal to the investor. The signal itself must be negative NPV project that simply burns money but it would give the positive signal to the investor.

Second the signal must be costly for weaker firms to adopt because that would be a high amount for the company and after that the company would not remain sufficiently profitable.

After meeting these two conditions a company would be able to give a positive signal to the investor.

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Debt Signaling A theory that states that an announcement regarding a firm's debt can be used as a signal of the stock's future performance. A company announcement regarding the issuance of debt is said to signal positive news, while an announcement that states that debt will be taken on at a future date is said to be a negative signal about the company. When a company agrees to take on more debt, it is making a commitment to pay interest on the debt. In doing so, it is showing that the company is in a stable financial situation. Conversely, when the amount of future debt is reduced, investors may see this as a sign that the company is unable to make its interest payments and is in a weak financial situation. So in this situation the firm will give a positive sign if the company has more leverage or debt to equity ratio and the firm will be having an image of a high quality firm in the eyes of the investor.

Equity Signaling Signaling theory is an idea of decision making of a firms financing. So the main idea of signaling theory is the firm will finance with its own funds which means from its internal sources. Internal sources are Retained Earnings, Reserve Fund, and Accumulated Fund etc. Financing from internal sources are more secured than external because cost of capital in internal source is less than external Sell bonds if stock is undervalued. And investors understand this, so view new stock sales as a negative signal. So when the company will generate capital through its financial assets or by issuing share instead of taking debt then that would create a negative signal that no bank trust on the company or the company might be vulnerable or Bankrupt.

Signaling Model

Signaling models typically predict that that the most profitable and the most promising firms will also pay the highest dividends and will have the highest debt to equity ratio that is in the theoretical case but actually rapidly growing technology companies tend not to pay any dividends at all. The companies which are in the position to pay high amount of dividend are mature companies that usually pay most of their earnings as dividends. The same is true for capital structures in which observed debt ratios tend to be inversely related to both profitability and industry growth rates.

Conclusion The finding of this assignment reconciles signaling theory with risk management theory. We contribute to the Dividend signaling theory by emphasizing the interaction between corporate risk management policy and dividend policy. The interaction between these two corporate policies has received less attention in the literature despite their common link to information asymmetry. Signaling theory is the most valuable tool in finance theory both because the early models have been modified to more accurately reflect reality and because the predict ions of these models in areas outside of dividend policy and capital structure have proven to be much more robust . This theory gives the best understanding of positive and negative signals to the investors and for making the investment discion.