Signaling Effects in Capital Structure: How Financial Decisions Influence Investors

A company's capital structure includes all of the sources of money that it receives from investors. The structure includes common stock, preferred stock, bonds, notes and other items. Investors only receive the firm's financial statements after the firm releases them, but managers are aware of the company's financial position at all times. The managers' financing decisions provide a signaling effect to investors that suggests whether the managers think the firm's securities are a good deal.

Stock Sales

Managers will sell stock if they think it will produce a gain for the company. When the company's stock is selling at a high price and managers think the stock is overpriced, they are willing to offer more stock. If the company's stock trades at a lower price than managers think it is worth, the managers won't sell stock and may even direct the company to buy back its stock.

Bond Sales

The firm will issue bonds if it can pay a low interest rate on the bonds. A bond sale at a higher interest rate than other companies offer suggests that no investors would buy the bonds at a lower rate, and that no investors are interested in purchasing the company's stock. The offer suggests that a bond purchase is risky because the firm is in trouble, even if the company has not reported a loss on its financial statements yet.

Stock Split

A stock split can also signal that a firm is a good purchase. The managers of a firm may decide that investors would purchase more of its stock at a certain price, such as $15 a share. If the value of a share increases to $30, the company can split each share into two smaller shares, each worth $15. The stock split is signaling further increases in the company's value, since managers would not need to split the shares if they thought the company's share price would drop back down later.

Credibility

The managers of a firm often own shares of the firm's stock, or hold stock options. According to Harvard Business School, the signaling effect is more credible when the managers make the same buying or selling decision as the firm itself. If the firm is buying back shares from other investors in the market, but its managers are selling large numbers of their own shares at the same time, it suggests that managers are trying to fool investors into thinking that the company's stocks are underpriced.