Companies allow a lot of information to be provided to the investors by media, special releases etc., but the investors do not get the insight at the current company’s condition. Managers of big and small companies possess more information on the value of stocks, current and future cash flows than the potential investors. As the managers tend to increase the profits of the investors, they need to use signals to accelerate the investors’ decisions. E.G. signaling might be used to notify the investors about the firm’s growth. It is used since there are companies with large and small cash flows and high and low quality levels, respectively.
Companies change their debt levels in two ways, using the exchange offers. These two types depend on the specifics of the investors, participating in the process. In case the first type is used, managers offer the stockholders an option of increasing the leverage, i.e. exchanging the stocks they hold for the debt of the company. Bondholders might partially or fully become the stockholders by exchanging their debts for the stocks of the company, which is used by the second type. Every company’s debt ratio indicates its value. The company becomes more attractive to the investors with rise of the debt ratio as the managers prove their belief in the company, allowing the overall increase of debt. It is known as Ross signaling argument for debt.
The size of the leverage ratio depends on the firm quality: high-quality companies prefer large ratio and the low-quality companies tend to use the lower leverage ratios. Market provides the company with its unique value based on the leverage ratio of one. The higher is the leverage ratio and the debt, correspondingly, the bigger is the probability of the company to turn a bankrupt. Since only big and high quality companies undertake such risks, their managers have to fully confident about the decision they take regarding the company. The main reason for the managers to do so is to increase the market value of the company and to attract the potential stockholders with the higher stock prices from the leverage ratio increase in the future. Using the technology, described above, managers signal to the investors in the most obvious form, proving the company’s profitability and reliability.
Investors believe to the signals so far as the low quality companies are not able to increase their leverage ratio without risking suffering a bankruptcy. On the other hand, high quality companies have better chances to avoid the bankruptcy due to the expert management, which leads to their signaling as reliable and credible options to the potential investors. This works the following way. The top company managers select the level of leverage for their business, and the second-best company managers have to show the lower ratio as they cannot undertake the same risk level as the top company does. This works for all the companies. Moreover, the debt level of the company corresponds to its personal cost of bankruptcy. Low debt corresponds to the low quality companies and the high debt follows the company of high quality with the highest expected bankruptcy cost to the manager. Due to this signaling is considered reliable and trustworthy by the investors.
The most important use of the theory of signaling is based on the total debt level of the company. Investors judge on the company’s quality during the decision making process. The debt level of the company is corresponding to its market value and attractiveness to the future investors.