Smith (1986) Raising Capital u Table 1: Stock market’s reaction to announcements of security offerings of various types Industrial/HI Growth Utility/LOW Growth Common stock-3.14%-0.75% Preferred stock-0.19*0.08* Convertible pref. stock Straight bonds-0.26*-0.13* Convertible bonds *: statistically insignificant

u Table 1: Stock market’s reaction to announcements of security offerings of various types –Average abnormal returns are non-positive. –Abnormal returns associated with common stock offerings are negative and larger in magnitude than those associated with preferred stock or debt. –Abnormal returns associated with convertible securities are negative and larger in absolute magnitude than for the corresponding non- convertible security. –Abnormal returns associated with sales of securities by high-growth companies are negative and larger in absolute magnitude than those for low-growth companies.

u Three hypotheses can potentially explain the above market reaction to new security offerings. u Optimal Capital Structure –There is an optimal debt-to-total capital ratio for a company. –Deviations from this optimal debt-to-total capital ratio will decrease company value. t (Question: Why would managers ever deviate from the optimal debt-to-total capital ratio?)

u Debt-Value Function: Movements along the curve. –D 0 to D 1 : Issuing equity. Company value goes down. Consistent with empirical evidence. –D 0 to D 2 : Issuing debt: Company value goes down: Evidence inconsistent with data. Value of Company Debt/Total Capital V0V0 D0D0 V1V1 D1D1 D2D2 V2V2

u Debt-Value Function: Shift of the curve. –Movements along the leverage value function cannot be differentiated from shifts in the function. –Hence, hypothesis is not very useful. Value of Company Debt/Total Capital V0V0 D0D0 V1V1 D1D1 D2D2 V2V2

 Implied Changes in Net Operating Cashflow –Firm’s cashflow identity: Market is trying to estimate net income by assuming only one other variable in the equation changes and the other four stay constant. –Table 2: Implied increase (decrease) in net income increases (decreases) share price. New debt + New equity + Net income = Interest payment + Dividend + New investment

Table 2: Implied increase (decrease) in net income increases (decreases) share price. Type of Announcement2-day Return (%) Implied INCREASE in expected cashflow Common Stock Repurchases Intra-firm tender offer16.2% Open mkt. Repurchase3.6 Dividend Increases Dividend initiation3.7 Dividend increase0.9 Special dividends2.1 Investment increases1.0

Table 2: Implied increase (decrease) in net income increases (decreases) share price. Type of Announcement2-day Return (%) Implied DECREASE in expected cashflow Security sales Common stock-1.6% Preferred stock0.1* Convertible preferred-1.4 Straight debt-0.2* Convertible debt-2.1 Dividend decreases-3.6 Investment decreases-1.1

u Implied Changes in Net Operating Cashflow –Explains non-positive market reaction to new equity offerings. Does not explain differential reaction to t debt and equity t convertible and non-convertible t high-growth and low-growth companies.

u Information Asymmetry –Market analysts are less well-informed about a firm’s intrinsic value than managers. –Managers will issue equity if t Funds are needed to finance a very high positive NPV project. t Firm’s stock is overvalued in the market. –Market assumes that managers are issuing equity, because the stock is overpriced. –Explains negative market reaction to equity offerings.

u Information Asymmetry (continued) –Since debt and preferred stock are more senior claims to equity, their value is less sensitive to changes in firm value. t Explains less negative market reaction to debt and preferred. –High-growth companies have greater information asymmetry. t Explains less negative market reaction to low- growth companies.

u Information Asymmetry (continued) –Since debt and preferred stock are more senior claims to equity, their value is less sensitive to changes in firm value. Value of Debt Claim Firm Value Value of Equity Claim Firm Value X X = Face Value of Debt X

u Two hypotheses explain most of the market’s reaction to new security offerings. –Implied Changes in Net Cashflow –Information Asymmetry