Debt Signaling
What Is Debt Signaling?
Debt signaling is a financial theory that connects a stock future performance with any current announcements made in regards to its debt. Announcements made about a company taking debt are commonly viewed as positive news as it can signal the company is reliable and is raising capital for the reasons for growth.
Understanding Debt Signaling
In the world of finances and economics, corporations are continuously seeking new growth opportunities. Investors normally decide if a these companies are embraced growth opportunities by hoping to direct or indirect signals they receive from corporations.
At times those signals come from the company's management team, yet they can likewise come from activities made by the company, including when the company says it will assume more debt. These are alluded to as debt signals. There debt signals can be both positive or negative, the two of which can immensely affect how a company's stock performs.
Companies can raise direct capital in two primary ways: through debt and through equity. Debt is much of the time the preferred method of financing over raising equity, since the cost of equity is normally higher than debt. Giving equity likewise a means of weakening ownership of a company to new investors, who get voting rights and a residual claim to profits and growth. At the point when a company goes with a choice to use debt financing through giving corporate bonds, investors might accept the company is on strong financial balance and actively seeking growth opportunities at lower financing costs than by means of giving stock.
Positive and Negative Debt Signals
The type of financing can signal the eventual fate of the company's financial position and any possibilities for projects the company might have. At the point when a company reports that it will assume more debt (commonly for another project), that signals sound financial health to investors and to the market, making it a positive debt signal. So when a company needs to assume more debt, that means it is committed to paying interest on it. The company additionally demonstrates that it trusts firmly in its project (and consequently, its financial wellbeing) and accepts that it will give quick returns — enough to pay down the debt and to give (financial) benefit to its investors.
If, then again, any future debt is reduced, [investors](/financial backer) may see this as a sign that the company can't make its interest payments and is in a weak financial situation. Likewise, in the event that the company decides to raise new equity as opposed to assume any debt, this is a negative debt signal. This means that a company needs more confidence in its financial situation or its projects, needs more profits, or can't raise sufficient debt.
Debt Signaling Example
In October 2017, online streaming and content producer Netflix announced it planned to bring about $1.6 billion up in debt. The company said it would involve the funds for general purposes, including funding for new satisfied. This was viewed as a positive step for the company, and consequently as a positive debt signal. Investors were apparently satisfied by the news, as the company's stock increased promptly following the announcement.
Features
- On the off chance that, then again, a company is forced to reduce its debt load or looks for capital through an equity offering, it very well might be seen by investors as a negative signal.
- At the point when a company expands its debt capital, particularly at great interest rates, it signals that the company is both trustworthy and fit for pursuing growth opportunities, making it a positive signal.
- Debt signaling theory proposes that corporate debt decisions can act as a dependable signal for outside equity investors.
