Signaling Effect Of Financial Structure

Stephen A. Ross in The Determination of Financial Structure: The Incentive-Signaling Approach believes that managers in a firm possess more information on both the profit and the risk of the firm than the investors who are only be able to perceive the value and managerial performances of the firm indirectly from the information signaled from the inside manager to the outside market, so that the asymmetric information makes corporate behaviors become the means of signaling the firm information. Debt Financing signals the potential performance of a firm to the market, for the action increases pressure on the firm to repay capital and interest, which implies managers boast confidence in the firm's future development; however, Equity Financing will be considered as an indication of the poor financial performance of the firm, as they keep the fact that the manager of the firm would never transfer the huge profit to would-be shareholders by issuing shares if the firm is well on the way. Thus the change of the firm's financial structure and its financing behaviors become the signaling channels of the firm information. The paper conducts an empirical investigation on the signaling phenomena of the change of financial structure in listed firms in China, based on the Ross's signaling hypothesis of the financial structure.Considering the current situation of the capital market and the character of the capital structure of the listed firms in China, the paper studies the contraction and the expansion of the financial structure respectively on the basis of the firm issuing additional new common shares and issuing convertible debt, and investigate empirically the signaling effect of the change of the financial structure on the three levels of testing whether the change of the financial structure truly transmits the prospect of the firm, whether it signals such information to the market, and whether the investors rightly receive the information which affects their decisions on the investment.According to the survey, the market shows a negative response to listed firms' additional offerings. The firms' action conveys a possibility of a worsening future, and the investors perceive the message which influences greatly on their investment decisions. That is the cause of the market's negative response. So the contraction of listed firms' financial structure, to some extent, signals the message of their poor development. However, the testing result of the firms issuing convertible debt is oppositely true that the expansion of the financial structure signals the positive information of the firms' good development to the market.