Question

1. According to Signaling theory, why does the stock price decline when a new stock offering is announced?

2. According to Modigliani and Miller theory, what happens to the value of a company when additional debt is issued? (assume corporate taxes exist)

3. With an optimal capital structure, what is maximized and what is minimized?

4. According to Windows of Opportunity theory, when will a company issue stock?

Answer 1

1) According to Signaling theory, why does the stock price decline when a new stock offering is announced?

Ans: Because the dividend signaling theory has been treated skeptically by analysts and investors, there has been regular testing of the theory. On the whole, studies indicate that dividend signaling does occur. Increases in a company's dividend payout generally forecast a positive future performance of the company's stock. Conversely, decreases in dividend payouts tend to accurately portend negative future performance by the company.

Many investors monitor a company's cash flow, meaning how much cash the company generates from operations. If the company is profitable, it should generate positive cash flow, and have enough funds set aside in retained earnings to pay out or increase dividends. Retained earnings is akin to a savings account that accumulates excess profits to be paid out to shareholders or invested back into the business. However, a company that has a significant amount of cash on its balance sheet can still experience quarters with low earnings growth or losses. The cash on the balance sheet might still allow the company to increase its dividend despite difficult times because they accumulated enough cash over the years.

If dividend signaling occurs with a company, the earnings could increase, but if it turns out that the company had accounting errors, a scandal, or a product recall, earnings could suffer unexpectedly. As a result, dividend signaling might indicate higher earnings in the future for a company as well as a higher stock price. However, it doesn't necessarily mean that a negative event couldn't occur before or after the earnings release.

2) According to Modigliani and Miller theory, what happens to the value of a company when additional debt is issued? (assume corporate taxes exist)

Ans: According to the MM theory when the interest on debt is tax-deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. The additional value equals the total discounted value of future taxes saved by issuing debt instead of equity.

3) With an optimal capital structure, what is maximized and what is minimized?

Ans: The Traditional Theory of Capital Structure states that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets is maximized, an optimal structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital. This point occurs where the marginal cost of debt and the marginal cost of equity are equated, and any other mix of debt and equity financing where the two are not equated allows an opportunity to increase firm value by increasing or decreasing the firm’s leverage.

4) According to Windows of Opportunity theory, when will a company issue stock?

Ans: A window of opportunity is a short, often fleeting time period during which a rare and desired action can be taken. Once the window closes, the opportunity may never come again. In a competitive market with many participants seeking to maximize tangible or intangible value for their constituents—whether owners, other shareholders, employees, or perhaps their community—the window will shut fast as soon as a good deal is recognized.

A window of opportunity can apply to a variety of situations, and sometimes they go unrecognized.

Also called the critical window, a window of opportunity is the short period of time within which some action can be taken that will achieve a desired outcome. Once this period is over, or the "window is closed," the chance to take the opportunity is no longer possible.

In some cases, it is possible to plan for and anticipate a window of opportunity and then act accordingly when the window opens. Many times, however, an opportunity arises that is unforeseen, and it is up to individuals to identify the opportunity and then to act on it. In situations with very brief or unpredictable windows of opportunity, automation may be employed to take advantage of these windows, as in algorithmic trading.