Signaling
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2signal
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Verb
sig·naled or sig·nalled sig·nal·ing or sig·nal·ling
sig·nal·er or sig·nal·ler noun
Definition of SIGNAL
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transitive verb
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1 : to notify by a signal <signal the fleet to turn back>
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2 a : to communicate or indicate by or as if by signals<signaled the end of an era>
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intransitive verb
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: to make or send a signal
Examples of SIGNAL
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b : to constitute a characteristic feature of (a meaningful linguistic form)
Robins signal the arrival of spring.
The election results surely signal the start of a new era.
A lock on the suitcase might signal that there's something of value inside.
Did he signal before he made the left turn?
They signaled at me to come over to their table.
He signaled us that it was time to begin the meeting.
The umpire signaled a strike.
First Known Use of SIGNAL 1805
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Signal is a message credibly conveying
information from informed to uninformed
players
It is credible
◦ if it is in the player’s interest to tell the truth
◦ it is too costly to mimic (to lie) by others
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Assumptions:
 Managers have better information about a firm’s
long-run value than outside investors
 Managers act in the best interests of current
stockholders
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Managers can be expected to:
◦ Issue stock if they think stock is overvalued
◦ Issue debt if they think stock is undervalued
◦ As a result, investors view a common stock
offering as a negative signal -- managers think
stock is overvalued
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Signaling theory, suggests firms should use
less debt than MM suggest
This unused debt capacity helps avoid stock
sales, which depress P0 because of signaling
effects
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One of the key assumptions Modigliani and Miller make in their work is that
market information is symmetric, meaning companies and investors have the
same information with respect to the company's future projects/investments.
This assumption, however, is not realistic. When making capital decisions, a
company's management should have more information than an investor,
which implies asymmetric information.
A financing decision is a way in which a company can inadvertently signal its
prospects to investors. For example, suppose Newco decides to finance a
new project with equity. Newco's additional equity would in fact dilute
stockholder value. Since companies typically try to maximize stockholder
value, would an equity offering be a bad signal? The answer is yes.
There would be some benefit from the project to the stockholders; however,
the dilution from the offering would offset some of that benefit. If a
company's prospects are good, management will finance new projects with
other means, such as debt, to avoid giving any negative signals to the
market.
Read more: http://www.investopedia.com/exam-guide/cfa-level1/corporate-finance/signaling-prospects-financingdecisions.asp#ixzz1wyHBmLGr