We begin this chapter with a review of the previous two chapters. This has two purposes: one to reinforce the material for the reader; the other, to allow this chapter to be read on its own. In particular, we are going to review and expand the discussion of asymmetric information and signaling from the earlier chapters. Then we will use MCI to illustrate how a firm’s operating strategy impacts its corporate financial policies.
A Brief Summary
We noted (in Chapters 8 and 9) that the following actions provide signals to the market. When a firm issues equity, its stock price drops on average. When a firm does a tender offer for its own shares, the firm’s stock price rises on average. When a firm initiates a dividend for the first time or raises its current dividend, the stock price goes up. When a firm cuts or eliminates its dividend, the stock price goes down. All of these price reactions are statistically significant.
In the last chapter, we stated that the market’s reaction to these events is due to asymmetric information. The insight behind why asymmetric information matters is that investors believe that managers have more information than they do, so investors therefore watch and react to what management says and does. A secondary insight is that investors don’t know whether what management is saying is credible or not. However, investors do know that if management increases the payout of equity ...