The Signalling theory - Essay Example

? THE SIGNALLING THEORY by + of The Signalling Theory Signalling theory posits the thought of sharing information. In economics, this is where one group plausibly conveys information to another about themselves. The theory originated from the concept of asymmetric information. In this case, business transactions were conducted in an unbalanced manner. The signalling theory thus provides equilibrium in relation to access to transactional information, allowing the parties involved to transact effectively. Similarly, human interactions rely on signals most of the time. The signals enable people to identify some hidden qualities of the other person. The theory focuses on providing comprehension of the varied signals as well as noting, which are dependable. For example, in making decisions, employers and managers rely on the information they obtain from the signals they receive. For instance, in making decisions about capital structures and payout policies, a manager would rely on the existing arrangement and try to evaluate its effectiveness before deciding on the next step (Chang & Hong 2000). Signals according to the theory can be categorized into assessment and conventional signals. The assessment signals denote the signals that are reliable; that is, they are signals that tend to restrict individuals who do not pose the quality required by the signal from using it. For example, if a manager perceives the organization to be overvalued, he or she should not signal the stakeholders that the organization holds a better opportunity in the future to increase profits by increasing their payouts. This is because implementing the signal will lead to embarrassment of the manager as well as create distrust. The conventional signals on the other hand denote unreliable indicators. In most cases, the signals are external and can result in heavy consequences. For example, if a manager makes a decision based on the consumer behaviour; for instance, seeing that the consumers are making high purchases of a product, the manager decides to produce these in high quantities perceiving that the profits for the organization will increase. This can be a false signal, especially when the consumer is presented with another alternative for the same product. The manager will lose face before the investors and can even be dismissed from office. Therefore, it is imperative to first identify the aspects affecting the capital structure and payout policies of the organization before signalling the respective parties or making any major decisions (Notes on Signalling 2005). Cost appears to be major factor in the signalling theory. This is because prior to making any decisions, managers need to consider the expense. At times, some signals may be deceiving and may later affect the decisions made adversely in a negative way. For example, the target earnings of the business may seem promising in the next quarter of the business thereby making the manager decide on a high pay out percentage. This signal could be truthful or deceiving and will eventually impact on the decision made for pay outs. On the other hand, deceptive signals can be used to benefit the creator of the signal. For instance, a manager can signal stakeholders and potential investors that the organization is well off to making more profits by increasing the payout ratio for their dividends. This would make them invest more in the organization and thus, enable the manager to expand the business and increase profits (Pacheco & Raposo 2007). Managers face the basic responsibility of deciding on the amount to debt to be employed on the capital structure as well as determine the dividend percentages to be paid out (Barclay et al. 1992). Different theories have been established to identify the aspects that are relevant in identifying capital structures and payout policies. Among these is the signalling theory. Aside from cost, taxes have also been noted to be a vital aspect that affects the capital structure and payout policies of organizations. Taxes impact on the worth of an organization. This is evidenced in the amount of deductions made to make payouts as well as in the way an organization dispenses its cash flow. For instance, by minimizing debt in the capital structure, an organization stands to reduce its tax liabilities and eventually enhance its cash flows. This essay will focus on the role that signalling theory plays in relation to decision making. Managers are always in touch with the organizational operations and performance. This factor contributes largely to the impact their decisions have on the capital structures and payout policies being implemented by the organization. Signalling and the Capital Structure The capital structure of an organization depends on the techniques implemented by managers to fund the organization’s operations. Most organizations use stocks and bonds. Debt as well as an organization’s equity varies in different modes. These modes offer a basis for signalling by the manager. For instance, agreements on debt usually necessitate an organization to turn a fixed deposit of funds payments above the life of a credit. Failure to pay will pose the danger of bankruptcy to the organization. On the other hand, equity provides the manager with a means of regulating the payout policies. For instance, the manager can decide to regulate the percentage payout by reducing, omitting or increasing the payouts in relation to the financial stand of the organization. Consequently, using the signal theory by totting up debt to the organization’s capital structure can act as a probable indication of increasing future cash flows. When the manager signals the need to pay bondholders, they present a positive picture that enables the investors to believe that the organization is performing well. However, if this signal fails to achieve the perceived benefits and leads to a drop in cash flow, the organization stands to lose its market share. The managers also risk losing their employment because of offering a false signal. The signalling theory has been noted to have major contributions on the decisions that managers make on debt and equity especially during issuance of the same and not on the general target of the organization’s capital structure (DeAngelo & DeAngelo 2000). Signalling and the Payout Policies Payout policies are usually considered contentious. This is because of the varied considerations on whether to pay or not to as well as determining what should be appropriate. Payout policies in form of dividends have been categorised into regular, extra, special and stock dividend (Harvey 1995). The regular dividends represent the payments that organizations issue on a habitual basis. The extra and special dividends denote payments that possibly will not and are not likely to be repeated respectively whereas the stock dividend signifies payments that are made from stock shares. In most case, managers determine their payout policies based on a target percentage of earnings. This aspect can lead to changes in decisions made by the manager. Perceived changes in the capital structure of an organization affects the way the organization communicates with the market. Payout policies such as dividends can be used as signals for communication by the manager. For example, if a manger decides to perceive the organization is comparatively close to reach their target leverage ratio, he or she can signal this by communicating an increase in dividend payment. This signal is interpreted positively by the stakeholders that the organization is operating profitably. However, the opposite is also true. If the signal turns out false, the manager will be required to deduct the payouts causing embarrassment to his leadership. This will also impact on the reaction by the stock market, in that; the market will also cut the stock prices. Calculations of signalling in Payout policies majorly depend on the way the managers perceive their organization. For example, when a manager recognizes the organization as a high quality one, they tend to make decisions that seek to increase the dividend payouts. If they consider the organization to be overvalued, their decisions will be to deduct the payments (Chang 1993). The Stock Market Reactions to these Decisions The stock market tends to react in a conventional manner depending on the signals received. For instance, if the signal indicates an increase in business transactions, it will react optimistically, if it signals a decrease in the same, the stock market will also react in a negative manner. Signalling, which is normally founded on the concept of asymmetric information provides the stock market with a foundation of determining the prospect of an organization. Alterations on the payout policies and capital structures provide the stock market with signals that enable it to determine market prices. For example, an increase in dividend payouts is normally taken as a sign of risk reduction and thus is interpreted positively by the stock market to determine the appropriate prices for the market. Additionally, the changes in manager’s decisions offer the stock market with signals of determining the future cash flows. When a manager decides to change the payout policy by increasing the dividend payouts, the stock market receives a signal of a probable increase in future earnings. Thus, the stock market will tend to follow suit in determining prices. Consequently, the decisions influence the operations of other organizations in the same market. For instance, if the manager of one organization perceives an increase in future cash flows, he or she will increase the dividends. This will trigger a reaction from other organizations who will seemingly want to compete with this organization. These responses create a competitive spirit in the stock market as well (Manos 2001). Subsequently, a decision to change the capital structure and payout policy affects the stock liquidity. A manager’s decision to instigate changes in dividend is an indication that the organization has a high stock liquidity as compared to its competitors. This signals a high return in future and subsequently affects the stock market by triggering an increase in prices. In a case where these signals turn out to be false, the stock market suffers major losses. Accordingly, it is vital for the stock market to measure the credibility of these signals before making major decisions (Brockman et al. 2008). The decisions by managers to change the capital structure and payout policy pose a threat to the development of the stock market. This is because depending on their interpretation of the signals, the stock market tends to determine players in the market. For instance, variations in the dividends tend to determine the level of risk and development of the market (Manos 2001). Thus, with a rise in market risk, the performance of the stock market is affected by the increase in reliance on external finance. For the state stock market to function effectively there is need to minimize participation and influence of external forces. This will enable the relevant cost of transactions to be low, and thus provide the stock market with adequate control of the organizations and ease of supervising the managers in decision making. Conclusion In summary, numerous theories exist to try to clarify the factors that affect capital structures and payout policies of organizations. Among them is the signalling theory. The theory denotes the concept of asymmetrical information in business transactions. It provides a comprehensive understanding of using signals in economics. The theory considers two varied types of signal; the assessment signals, which are normally considered reliable because they act as prohibitive factors to individuals without necessary requirements or qualities to use a signal. Assessment signals are commonly considered the ability of an organization to act on a signal without having to strain its resources. For example, an undervalued organization stands a better chance to increase its dividends basing on the signal it obtains of future increase in cash flows as compared to an organization that is overvalued. Consequently, the conventional signals denote signals that are usually considered unreliable. In most cases, these include signals from external environment. Prior to making major decisions, managers often consider the issue of costs and taxes. Cost can be considered in terms of payments made to the stakeholders as well as the overall fee of operations. On the other hand, taxes affect the amount of deductions to be made for the payments as well as capital to be reinvested in the organization. These factors are notably the major aspects that contribute to the controversial nature of dividends. Aspects of cost and taxation tend to vary in relation to the market performance. Whereas a manager may perceive a signal to indicate a possible increase in cash flow in the future for the organization, causing him or her to increase the dividends to the stakeholders, this may not happen, the market variations of cost and taxes may result in the opposite, and this may cause adverse negative influence on the manager and the organization. Thus, in a way, the signalling theory provides a base for decision making by managers. This is because it provides a measure of predicting the organization’s performance in the market. Depending on the perceptions, managers can design the capital structures and payout policies in a way that is beneficial for the organization. This helps to avoid making inappropriate decisions that could lead the organization to bankruptcy. Additionally, the stock market is affected by the decisions made by managers in relation to changing the capital structure and payout policies of their organization. These decisions influence the level of liquidity of the organization and provide the stock market with a basis of determining market prices. Depending on the capital structure and payout policy of an organization, managers can decide on the amount of dividend to issue in relation to their perceived performance of the organization in future. If these signals fail to work as perceived, the managers are at risk of losing their job and affecting the functioning of the stock market. Therefore, the managers and stock market officials should evaluate the credibility of the signals before making any major changes. References List Barclay, M, Smith, C & Watts, R 1992, The determinants of corporate leverage and Dividend policies, Available at: http://thefinanceworks.net/Workshop/1002/private/7_Capital%20Structure/Articles/Barclay%20Smith%20Watts%20on%20capital%20structure%20evidence%20JACF%201995.pdf [Accessed on 27 February 2013] Brockman, P, Howe, J & Mortal, S 2008, ‘Stock market liquidity and the decision to Repurchase’, Journal of corporate finance, vol. 14, pp. 446-459. Available at: https://umdrive.memphis.edu/scmortal/public/papers/Brockman+howe+mortal%20-%20jcf%20-%20LiquidityPayoutPolicy.pdf [Accessed on 27 February 2013] Chang, C 1993, ‘Payout policy, capital structure, and compensation contracts when managers value control’, The review of financial studies, vol. 6, no. 4, pp. 911-933. 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