Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

Signaling Consideration

Signaling is the conveyance of nonpublic information through public action, and is often used as a technique in capital structure decisions.


LEARNING OBJECTIVE

  • Explain how a company's attempts at signaling can affect its capital structure

KEY POINTS

    • Signaling becomes important in a state of asymmetric information.
    • Signaling can affect the way investors view a firm, and corporate actions that are made public can indirectly alter the value investors assign to a firm.
    • In general, issuing new equity can be seen as a bad signal for the health of a firm and can decrease current share value.
    • 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 in order to avoid the possibility of sending a negative signal.

TERMS

  • asymmetric information

    State of being regarding decisions on transactions where one party has more or better information than the other.

  • Signaling

    The idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal).

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 the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of 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 workers talents and motivation.

In terms of 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 that is issuing new equity. If a company issues new equity, this generally dilutes share value. Since the goal of the firm is generally to maximize shareholder value, this can be a viewed as a signal that the company is facing liquidity issues or its prospects are dim. Conversely, a company with strong solvencyand 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 the company's 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 in order to avoid the possibility of sending a negative signal.