Costless Versus Costly Signaling In Capital Markets: Theory And Evidence

Abstract

Why is the mere announcement of an open-market share repurchase program, which involves no commitment to purchase shares, regarded as good news by the market? The first part of this paper provides a theoretical model to resolve this puzzle. The model predicts that firms with large underpricing can attract attention by announcing repurchases, and these firms do not have to use costly share repurchases as a value-correcting signal, because the trades from speculators lead to value corrections. Firms with small underpricing, however, cannot attract attention by announcing repurchases, and these firms have to use costly share repurchases as a value-correcting signal. The second part of the paper finds empirical evidence in favor of the predictions of the theoretical model.