Capital Structure Considerations

Signaling Consideration

In economics and finance, signaling is the idea that a party may indirectly convey information about itself, which may not be public, through actions to other parties. Signaling becomes important in a state of asymmetric information (a deviation from perfect information), which says that in some economic transactions, inequalities in access to information upset the normal market for exchanging goods and services.

In his seminal 1973 article, Michael Spence proposed that two parties could circumvent the problem of asymmetric information by having one party send a signal to reveal some relevant information to the other party. That party would then interpret the signal and adjust its purchasing behavior accordingly – usually by offering a higher or lower price than if the signal had not been received. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value.

A basic example of signaling is that of a student to a potential employer. The degree the student obtained signals to the employer that the student is competent and has a good work ethic – factors that are vital in the decision to hire.

Signaling Education credentials, such as diplomas, can send a positive signal to potential employers regarding a worker's talents and motivation.

Regarding capital structure, management should, and typically does, have more information than an investor, which implies asymmetric information. Therefore, investors generally view all capital structure decisions as some sort of signal.

For example, let us think of a company issuing new equity. If a company issues new equity, this generally dilutes share value. Since the firm's goal is generally to maximize shareholder value, this can be viewed as a signal that the company is facing liquidity issues or its prospects are dim.

Conversely, a company with strong solvency and good prospects would generally be able to obtain funds through debt, which would generally take on lower costs of capital than issuing new equity. If a company fails to have debt extended to it or its credit rating is downgraded, that is also a bad signal to investors. While the issuance of equity does have benefits, in the sense that investors can take part in potential earnings growth, a company will usually choose new debt over new equity to avoid the possibility of sending a negative signal.