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Dividend Policy decisions and Capital Structure decisions in relation to Signaling THeory - Essay Example

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Signaling is the model that involves one party (the agent) conveying some important information with regard to himself/herself to another party, (the principal). Signaling has its roots in asymmetric information that states that in some economic transactions, inequalities in…
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Dividend Policy decisions and Capital Structure decisions in relation to Signaling THeory

Usually the principal will offer a higher price than if she/he would not have received the signal. The assumptions underlying information asymmetry are that managers are better informed in relation to investors and will act to the best interest of current shareholders.
The signaling theory assumes that managers and investors have same information but managers usually having better information. Thus, the managers would sell stock if overvalued and bonds if stock is undervalued. The investors clearly understand this and, therefore, view new stock sales as a negative signal. From the fact that information asymmetry is well known to all, how a company raises capital becomes a signal. The major implications of information asymmetry are: when the company’s prospects are poor the there is overvaluation of stock as nobody knows except the insiders, everything is financed with stock thus the company can raise more money at a lower cost; and when the company’s prospects are good then there is undervaluation of stock thus the company uses debt to finance. Overvaluation of stock assumes that once the stock falls, sharing of losses is by old and new stockholders favoring the old stockholders whereas undervaluation assumption is when the stock prices goes high only the old stockholders will benefit from the gains. This may be simply represented as follows:
The signaling view in relation to dividend policy argues that changes in dividend amounts are signals of paramount importance to the investors about management’s changes expectation of future earnings (Duke,edu para 1). It is the belief of many that the amount per share companies’ pay as dividends is a clear indication of the management’s belief about future earnings. A decline in the dividend amount from a previous high amount is an indication that the management anticipates a decline in future earnings. It is a practice by most ... Read More
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