The Signalling theory Essay Example | Topics and Well Written Essays - 1750 words

The Signalling theory - Essay Example Similarly, human interactions rely on signals most of the time. The signals enable people to identify some hidden qualities of the other person. The theory focuses on providing comprehension of the varied signals as well as noting, which are dependable. For example, in making decisions, employers and managers rely on the information they obtain from the signals they receive. For instance, in making decisions about capital structures and payout policies, a manager would rely on the existing arrangement and try to evaluate its effectiveness before deciding on the next step (Chang & Hong 2000). Signals according to the theory can be categorized into assessment and conventional signals. The assessment signals denote the signals that are reliable; that is, they are signals that tend to restrict individuals who do not pose the quality required by the signal from using it. For example, if a manager perceives the organization to be overvalued, he or she should not signal the stakeholders tha t the organization holds a better opportunity in the future to increase profits by increasing their payouts. This is because implementing the signal will lead to embarrassment of the manager as well as create distrust. The conventional signals on the other hand denote unreliable indicators. In most cases, the signals are external and can result in heavy consequences. For example, if a manager makes a decision based on the consumer behaviour; for instance, seeing that the consumers are making high purchases of a product, the manager decides to produce these in high quantities perceiving that the profits for the organization will increase. This can be a false signal, especially when the consumer is presented with another alternative for the same product. The manager will lose face before the investors and can even be dismissed from office. Therefore, it is imperative to first identify the aspects affecting the capital structure and payout policies of the organization before signalling the respective parties or making any major decisions (Notes on Signalling 2005). Cost appears to be major factor in the signalling theory. This is because prior to making any decisions, managers need to consider the expense. At times, some signals may be deceiving and may later affect the decisions made adversely in a negative way. For example, the target earnings of the business may seem promising in the next quarter of the business thereby making the manager decide on a high pay out percentage. This signal could be truthful or deceiving and will eventually impact on the decision made for pay outs. On the other hand, deceptive signals can be used to benefit the creator of the signal. For instance, a manager can signal stakeholders and potential investors that the organization is well off to making more profits by increasing the payout ratio for their dividends. This would make them invest more in the organization and thus, enable the manager to expand the business and increase pro fits (Pacheco & Raposo 2007). Managers face the basic responsibility of deciding on the amount to debt to be employed on the capital structure as well as determine the dividend percentages to be paid out (Barclay et al. 1992). Different theories have been established to identify the aspects that are relevant in identifying capital structures and payout policies. Among these is the signalling theory. Aside from cost, taxes have also been noted to be a vital aspect that affects the capital struc