Question

Apple Incorporated (AI) board of directors has indicated that they will repurchase AI’s stock effective July 1st, 2020. You currently hold 100 AI’s stock. Explain in detail, the concept of “information content” to be derived from the board of director’s pronouncement. Discuss the likely impact of this pronouncement on AI’s stock price? In respect of this announcement, discuss the concept of the “signaling theory” and how will managers of AI be placed in an advantageous position ahead of the normal investor? (Word count limit(250-500)

Answer 1

Signaling theory:

Signaling theory helps researchers and managers better understand communication under conditions of imperfect information. A signal is an action or statement conveying a person's or firm's capabilities or intentions and discloses a range of information. Signaling theory posits a rational customer expecting a firm to honor his or her commitments because of potential for economic punishment through termination of repeat purchasing. Some firms, however, may choose to signal false claims if initial financial payoffs outweigh future losses once the truth becomes known.

At the end of the 70's, Ross (1977), and other writers developed the capital structure signaling theory based upon the problems of the asymmetrical information between managers and investors. These models are based upon the idea that the top executives of the firm that have inner information, have a motive to transfer this knowledge to the external investors, so that the stock price will rise. However, managers cannot simply announce the good news to the investors, since they will face it with suspicion. One solution to this problem (for the underestimated firms) is to send to the investors a signal containing this information, by adopting a financial policy. This strategy is forbidden from the aspect of cost for a firm of less value.

The economist who first dealed with the asymmetric information was Akerlof with his Lemons Problem, which concerned the car market. Michael Spence continues Akerlof's idea, in his article (1973), in which he introduces the notion of the signaling theory in the labor market. In 2001, Akerlof, Spence and Stiglitz were nominated with the Nobel Prize for their research on the asymmetrical information during the 70's. This is a sign of the importance of the financial asymmetric information.