What Is the Signaling Theory of Mergers? What Is the Relationship Between Signaling and the Mode of Payment Used in Acquisitions?

The signaling model assumes that managers with favorable inside information have an incentive to convey this information to outside investors in order to increase the firm's stock price (Scott, Megginson, Gitman, 2007, p502). They cannot simple announce this good news to investors because shareholders may be skeptical about such announcement. Therefore, the solution to this problem of information asymmetry is for managers of firms with goods news to announce to "signal" such news to investors. They do so with the aim to maximize shareholders' value through various management decisions or actions, adopting some financial policy and the same would be too costly to imitate by less valuable firms.

Based upon the same theory, the model further explains that when manager use a specific mode of payment to acquire a firm, they signal inside information to the capital markets. They will finance acquisitions with the cheapest source of capital available. For instance, financing an acquisition with equity signals to the market that equity is a relatively cheap source of capital because the acquirer's stock price is overvalued. As soon as the market receives the signal, the market will adjust the stock price by lowering it to the suitable level so that it is no more overvalues.

Similarly managers may opt for a heavily leverage capital structure to finance an acquisition if they know the investment huge cash flows in the future. And that is a mean of conveying the good news to the market. Since investors believe that only companies with good prospects can afford to borrow (not at high cost linked to perceived risks by lenders), they will bid up the company's share and thus taking the debt issuance as good news.

Reference

Scott B. Smart, William L. Megginson, Lawrence J. Gitman. 2007. Corporate Finance (second edition).