Capital structure decisions as signals of firm future prospects

Capitalism is structured as a means of obtaining economic benefit through investment in various assets. By foregoing current consumption of goods and services, and instead investing excess capital, the investor intends to consume more goods and services in the future. These investments should compensate the investor for the risk associated with the security relative to the market, the time value of money, and finally inflation. In order to attract capital from investors, individual companies indirectly signal their underlying financial health by engaging in various activities. These activities include share buybacks, dividend increases, and stock splits. In the subsequent sections, we will be discussing the merits of each

Stock buyback is one method used to signal the financial health of the underlying company. Share buybacks are used primarily to limit the amount of shares available to the public by purchasing a particular quantity of the company's own shares. By purchasing its own shares, the company first increases the market value of the remaining shares within the market, while also signaling that the company believes its shares are undervalued relative to the market valuation. This mechanism serves current stockholders well, because it limits the dilution of shares outstanding. With fewer shares outstanding, the earnings of the company are spread across fewer individual stock holders which again increase value of each stock. Stock buyback indicate the financial health of the company due in part to the large capital requirements needed to initiate the purchase originally. If a company is in financial distress, share buybacks are generally not undertaken. This is because the capital used to repurchase shares could be better allocated to endeavors that will improve the overall operations of the business. Thus, when firms do engage in share buybacks they are in essence demonstrating their financial health to potential investors.

A dividend increase is a very common method used to display financial health. Dividends are essentially a distribution of the company's earning per share to those of the individual stockholders. Through dividend increases, the company is giving more of its earnings to each individual investor. This is usually undertaken when a corresponding increase in earnings is prevalent. Earnings increase combined with liability decreases often signal a financially viable company. Companies do not usually engage in dividend increases unless an offsetting amount of earnings is present. Without this offsetting amount of earnings, the company is retaining less capital in the firm which could be detriment to future growth. This is because with less capital retained in the firm, the firm can not participate in investment activities for the benefit of the future earning growth of the company. As such, companies usually don't increase dividends unless future earnings growth looks very favorable in the future.