Corporate Finance

Essay by madittaUniversity, Bachelor's March 2010

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Q. 3

A. Analyse how signaling models attempt to explain the proportion of equity retained by an entrepreneur, stock repurchases, the type of financing used for an investment and under pricing in initial public offers.

The Information Asymmetry hypothesis recognizes informational differences between buyers and sellers, since market participants do not have homogenous expectations. Managers typically have better information about the value of their companies and own projects than outside investors. Recognition of this information asymmetry between borrowers and investors has led to two distinct but related theories of capital structure decisions: the Signaling theory and the Pecking Order theory.

The Signaling theory

Assuming that firm managers have superior information about the true value of the company, managers of undervalued firms would attempt to raise their share prices by communicating this information to the market. Unfortunately, economic theory suggests that information disclosed by an obviously biased source (e.g. Management) will be credible only if the costs of communicating falsely are large enough to force managers to reveal the truth.

The challenge for managers is to find a credible signaling mechanism. Increasing leverage is suggested as an effective signaling device i.e. debt contracts oblige the firm to make interest and principle payments; if these obligations are not met, the firm risks financial distress and ultimately bankruptcy. Equity is more relaxed, as managers have more discretion over payments (dividends) and can cut or omit them in times of financial distress. Thus, adding more debt to a firm's capital structure can serve as a positive signal of higher future cashflows and that the firm feels strongly about its ability to service debt into the future. (Chew, 2001)

Alternatively, a firm's current market valuation may direct management to reflect excessive confidence about the future (i.e. stocks are overvalued by the market). Managers may...