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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.

'

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.