Costless Versus Costly Signaling in Capital Markets: Theory and Evidence

A good type can separate itself from a bad type by giving a costly signal; the bad type will not mimic because the signal is costlier for the bad type. A good type can also separate itself from a bad type by attracting scrutiny; the bad type will not mimic because the bad type will not risk attracting scrutiny and being discovered. The contribution of this paper is to develop a simple model to find out which separation method will be used in the context of a firm signaling its value to a capital market. We then test the predictions of the model – costless signaling is more likely to be used by more ignored and more undervalued firms – using a data set that contains firms that employ costless signals (25% of firms that announce open market share repurchases do not do it) and firms that employ costly signals (75% of firms that announce open market share repurchases do it). The evidence in favor of the predictions of the model is surprisingly robust.