Signaling Theory

MM assumed that investors have the same information about a firm's prospects as its managers—this is called symmetric information. However, in fact managers often have better information than outside investors. This is called asymmetric information, and it has an important effect on the optimal capital structure. To see why, consider two situations, one in which the company's managers know that its prospects are extremely positive (Firm P) and one in which the managers know that the future looks negative (Firm N).

Suppose, for example, that Firm P's R&D labs have just discovered a non-patentable cure for the common cold. They want to keep the new product a secret as long as possible to delay competitors' entry into the market. New plants must be built to make the new product, so capital must be raised. How should Firm P's management raise the needed capital? If it sells stock, then, when profits from the new product start flowing in, the price of the stock would rise sharply, and the purchasers of the new stock would make a bonanza. The current stockholders (including the managers) would also do well, but not as well as they would have done if the company had not sold stock before the price increased, because then they would not have had to share the benefits of the new product with the new stockholders. Therefore, one would expect a firm with very positive prospects to try to avoid selling stock and, rather, to raise any required new capital by other means, including using debt beyond the normal target capital structure.12

12It would be illegal for Firm P's managers to personally purchase more shares on the basis of their inside knowledge of the new product. They could be sent to jail if they did.

Now let's consider Firm N. Suppose its managers have information that new orders are off sharply because a competitor has installed new technology that has improved its products' quality. Firm N must upgrade its own facilities, at a high cost, just to maintain its current sales. As a result, its return on investment will fall (but not by as much as if it took no action, which would lead to a 100 percent loss through bankruptcy). How should Firm N raise the needed capital? Here the situation is just the reverse of that facing Firm P, which did not want to sell stock so as to avoid having to share the benefits of future developments. A firm with negative prospects would want to sell stock, which would mean bringing in new investors to share the losses!11'

The conclusion from all this is that firms with extremely bright prospects prefer not to finance through new stock offerings, whereas firms with poor prospects like to finance with outside equity. How should you, as an investor, react to this conclusion? You ought to say, "If I see that a company plans to issue new stock, this should worry me because I know that management would not want to issue stock if future prospects looked good. However, management would want to issue stock if things looked bad. Therefore, I should lower my estimate of the firm's value, other things held constant, if it plans to issue new stock."

If you gave the above answer, your views would be consistent with those of sophisticated portfolio managers. In a nutshell, the announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its management are not bright. Conversely, a debt offering is taken as a positive signal. Notice that Firm N's managers cannot make a false signal to investors by mimicking Firm P and issuing debt. With its unfavorable future prospects, issuing debt could soon force Firm N into bankruptcy. Given the resulting damage to the personal wealth and reputations of N's managers, they cannot afford to mimic Firm P. All of this suggests that when a firm announces a new stock offering, more often than not the price of its stock will decline. Empirical studies have shown that this situation does indeed exist.14

What are the implications of all this for capital structure decisions? Because issuing stock emits a negative signal and thus tends to depress the stock price, even if the company's prospects are bright, it should, in normal times, maintain a reserve borrowing capacity that can be used in the event that some especially good investment opportunity comes along. This means that firms should, in normal times, use more equity and less debt than is suggested by the tax benefit/bankruptcy cost trade-off model expressed in Figure 13-3.

Finally, the presence of asymmetric information may cause a firm to raise capital according to a pecking order. In this situation a firm first raises capital internally by reinvesting its net income and selling off its short-term marketable securities. When that supply of funds has been exhausted, the firm will issue debt and perhaps preferred stock. Only as a last resort will the firm issue common stock.

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Debt Free Network Marketing

Debt Free Network Marketing

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