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  • 1 Kelley School of Business, Indiana University, Bloomington, IN 47405. Email: ubhattac@indiana.edu

    2 Kelley School of Business, Indiana University, Bloomington, IN 47405. Email: adittmar@indiana.edu

    * This paper has benefitted from the response of seminar participants at Alabama, Humboldt, Frankfurt,Illinois, Indiana, INSEAD, Norwegian School of Management, Notre Dame, Penn State and Pittsburgh.

    Costless Versus Costly Signaling:Theory and Evidence

    from Share Repurchases*

    by

    Utpal Bhattacharya1

    and

    Amy Dittmar2

    JEL Classification: D80, G14, G30Key Words: Cheap talk, costly signals, share repurchases

    First version: January 2001This version: February 2003

  • COSTLESS VERSUS COSTLY SIGNALING:

    THEORY AND EVIDENCE FROM SHARE REPURCHASES

    Abstract

    When does a good firm separate itself from a bad firm by putting its money where its mouth is and

    when does it engage in cheap talk? We develop a simple model in this paper to find out which signaling

    mechanism will be used under what circumstances in a capital market. We find, as one would expect, that

    the good firm prefers cheap talk over costly signaling, because in the latter method, all of the cost of

    separation is being borne by the firm. However, costless signaling can only be used by good firms who are

    more undervalued and are more ignored. These restrictions exist because cheap talk will only attract attention

    from speculators when scrutiny is likely to uncover more opportunities for trading profits that will cover the

    costs of scrutiny. We then test the predictions of the model using a data set of open market share repurchases

    that contains firms that employ costless signals (announce share repurchases, but do not repurchase) as well

    as firms that employ costly signals (announce share repurchases, and repurchase). The evidence in favor of

    the predictions of the model is surprisingly robust.

  • 1

    COSTLESS VERSUS COSTLY SIGNALING:

    THEORY AND EVIDENCE FROM SHARE REPURCHASES

    When does a good firm separate itself from a bad firm by putting its money where its mouth is and

    when does it engage in cheap talk? Signaling theory predicts that a good firm can separate itself from a bad

    firm by giving a costly signal to capital markets; the bad firm will not mimic because the signal is costlier for

    the bad firm. A good firm can also separate itself by engaging in cheap talk to attract scrutiny; the bad firm

    will not mimic because the bad firm does not gain from being discovered. This paper explores, both

    theoretically and empirically, when do good firms use costly signals to separate and when they use costless

    signals to separate.

    The first contribution of this paper is to develop a simple theoretical model that gives a good firm the

    choice between costless and costly signaling in a capital market. This allows us to make precise the

    circumstances under which each signaling mechanism will be used. We obtain the following insights from

    our theoretical model. The good firm always prefers costless signaling over costly signaling because, in the

    latter method, all of the cost of separation is being borne by the firm; whereas, in the former method, all of

    the cost of separation is being borne by a speculator who, after his attention has been attracted, finds it

    optimal to expend search costs to find out more about the firm. The good firm is, thus, discovered. The bad

    firm does not gain from being discovered, and so it does not attract attention. Separation by costless signals,

    however, is effective only under very special circumstances in a stock market. This is because the speculator

    will only undertake search if he hopes to discover substantial material non-public information about a firm

    and then make substantial trading profits to cover the cost of scrutiny. As only good firms, i.e. only

    undervalued firms, signal in equilibrium, substantial material non-public information can only be obtained

    if the firm is deeply undervalued. Second, the discovery of substantial material non-public information about

    a firm is useless if many other speculators discover the same information and compete away all trading

    profits. In other words, if the size of informed trading increases, stock prices become more informative, and

    so the value of the additional information that can be obtained from costly search diminishes. To summarize,

  • 2

    our theoretical model predicts costless signals are effective for more undervalued firms and for more ignored

    firms. For other firms, this signaling mechanism will not work, and they have to put their money where their

    mouths are employ costly signals.

    The second contribution of our paper is to take the above two testable implications of our theoretical

    model to the data. To test our model, we need a signaling mechanism that allows a firm a choice between

    a costly and a costless signal. Our data set consists of a sample of firms that have announced open market

    share repurchases. This data set offers a unique opportunity to test the predictions of our theoretical model,

    because we find that 46% of all firms that announce share repurchase programs do not purchase a single

    share within the quarter of or the quarter following the announcement. As a matter of fact, 27% of firms that

    announce, do not repurchase within four fiscal years of the announcement or prior to dropping out of

    Compustat. Thus, if a repurchase announcement signals value, then these firms simply use the

    announcement, which is virtually costless, to attract scrutiny from speculators and have their true value

    discovered, whereas the rest of the firms repurchase their shares, which is costly, to signal their true value.

    The differences between these two sets of firms should shed some light as to which type of firms use costless

    signaling and which type of firms use costly signaling, enabling us to test the predictions of our model.

    We test the predictions of our theoretical model using proxies for measuring the two variables of

    interest. Our proxy for measuring our first variable of interest, undervaluation, is the amount of positive

    information that comes out at the announcement or between the announcement date and the time the firm

    reveals if it has used a costly or a costless signal. Since firms do not report stock repurchases until they file

    their quarterly statements, the market may not know the type of signal until the close of the next fiscal quarter.

    Thus, we assume that the signal corrects the undervaluation within t days after the announcement where

    we take t to be one day, one quarter or two quarters. A classical measure of the amount of undervaluation

    is the abnormal returns from the announcement till date t, and this is what we use. Our primary proxy for

    measuring our second variable of interest, ignorance, is the number of analyst following. We also use firm

    size since the market is typically better informed about large versus small firms.

  • 3

    The following are our results from our empirical tests. We find that firms that announce share

    repurchases and do not carry them out, have higher cumulative abnormal returns over the announcement

    period, have fewer analysts following them, and are smaller than firms which announce share repurchases

    and carry them out. These results indicate that firms that are more undervalued and are more ignored are

    more likely to use a costless signal. These two pieces of evidence provide strong support for our model.

    Our theoretical model liberally borrows insights from two strands of a vast signaling literature. The

    first strand, the costly signaling literature, began with Spence (1973). He showed that if the cost of the signal

    is higher for the bad type than it is for the good type, the bad type may not find it worthwhile to mimic, and

    so the signal could be credible. Riley (1979) formalized the conditions under which such costly signaling

    equilibria exist. Numerous papers giving examples of such costly signaling in capital markets followed. An

    early paper was by Ross (1977), who showed how debt could be used as a costly signal to separate the good

    from the bad. The second strand, the cheap talk literature which we call costless signaling in this paper,

    began with Crawford and Sobel (1982). They showed that cheap talk, defined as a costless, non-binding,

    and unverifiable message, could also be a credible signal. They modeled a two-player non-cooperative

    information transmission game between a Sender and a Receiver. They demonstrated that the optimal

    response of the Receiver after a signal is received may affect the utility of the Sender in a way that it may be

    optimal for the Sender to tell the truth. In capital markets, an early paper was by Brennan and Hughes (1991),

    who modeled how good firms doing costless stock splits could motivate brokers to provide favorable reports

    about them.

    In a recent paper, Austen-Smith and Banks (2000) have also allowed both costless and costly

    signaling. The main difference between their model and ours is that they view the two types of signals as

    complements in a general framework, whereas we model them as substitutes in the specific context of

    signaling to capital markets. This means that the focus in Austen-Smith and Banks (2000) is on how costly

    signals can improve cheap talk communication, whereas the focus in our model is on when costly s

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