SIGNALLING THEORY

Signalling Theory

Signalling Theory and Manager's Decision

Introduction

Capital structure has an essential role in firm performance maximization and firm's value. According to finance theory, capital structure engrosses decisions concerning the combination of various fund sources, since firm use these sources of fund to finance their assets, operations and capital investments. These sources of finance include long-term and short term debt finance i.e. debt financing, beside this company also finance through common and preferred stock i.e. equity financing. Capital structure has direct relations with the firm performance and this has been highlighted by many theories that are Agency theory, Theory of information asymmetry, Trade of f theory and Signalling Theory.

This paper will be discussing discuss how Signalling Theory explains a manager's decision to change capital structure and payout policy. Beside this, the discussion would also be focusing on the stock market responds to the decisions.

Discussion

Signalling Theory

Signalling Theory founded by Stephen Ross which was an initiation for the short coming of the theory of markets in equilibrium. The concept behind this theory is that information is the not shared to each individual at the same time i.e. the rule of information asymmetry is applied here. This might be a negative consequence since this can leads valuation be too low or a sub optimal investment policy (Brigham, Ehrhardt, 2012, p. 1019).

The basis for this theory based on two simple ideas which are:

Same information is not shared by all users: for example, officers of a corporation may have information that investors do not have;

Even if it was shared by all users, the same information is not perceived in the same way that everyday confirms frequently.

Hence, financial variables that are manipulated by leaders to report the true value of their business can be of different nature, including the share of equity held by managers, the level of debt and dividend policy. These are obviously the signalling models based on dividends, on capital increase and debt that will be presented here (Laffont, 2012, p. 64).

Signalling theory and capital Structure

Taking into account asymmetric information between market participants, this has created a theory of signals. This theory assumes that a person closely associated with the firm have better information on future cash flow streams from other market participants. According to this theory, the market price of the shares does not include information that is not publicly available. Signal Theory repeals the original assumption conditioning MM theory that the perfect market all market players have full and equal information concerning the company's business (Chahyadi, 2012, p. 12).

Empirical studies have shown that information asymmetry is an important determinant of capital structure formation and selection of assets issued by the management company.

Signalling theory assumes that changes in the degree of financial leverage a management response to changes in current and expected financial standing of the company, which the market interprets as signals regarding the expectations of their development prospects of the company. With asymmetric information managers are trying to convince investors that the company is managed by them is worth more than ...