Smith C. RAISING CAPITAL: THEORY AND EVIDENCE in Chew D. (ed.) The New Corporate Finance McGrawHill 1993 Article has 2 basic aims: theory and evidence of market response to security offer announcements evaluate different methods of marketing corporate securities Market Reactions to Security Offer Announcements: negative (see Table 1) Possible explanations: EPS dilution Price pressure (downward sloping curve) Optimal capital structure Insider Information Unanticipate Announcements Ownership Changes Alternative Methods of Marketing Security Offerings Rights versus firm-commitment underwritten offerings Negotiated versus Competitive Bid Contracts Shelf versus Traditional Registration IPOs Underpricing Best Efforts versus Firm Commitment Contracts Stabilization Activity and the Gree Shoe Option
Security Offer Announcements EPS Dilution against Efficient Market Hypothesis no credible supporting evidence Price Pressure only risk and expected returns markets many substitutes Scholes: large block offerings decline unrelated to the size little empirical evidence Optimal Capital Structure do new security offering move away companies from optimum? Not credible Information Disparity Between Management and Potential Investors Implied Changes in Net Operating Cash Flow New Investment Expenditure Reduction in some liability Increase in future dividends Reduction in expected op. Cash flow Information Disparity Stock issue when overvalued? Leverage change Look at pure financial structure changes Unanticipated Announcements Stock price change larger if announcement unanticipate Debt issue more predictable Utilities use external capital markets more frequently Changes in Ownership and Control Security sales = signal Example: carve out Sale of minority offering of a whollyowned subsidiary
Smith (1993) Table 1 Average two-day abnormal common stock returns Types of Issuers Type of Security Offering Industrial Utility Common Stocks -3.14% -0.75% Preferred Stocks -0.19% +0.08% Convertible Preferred Stock -1.44% -1.38% Straight Bonds -0.26% -0.13% Convertible Bonds -2.07% n.a.
Smith (1993) Table 2 Type of Announcement 2-Day Announcement Period Return Implied Increase in Corporate Cash Flow Intra-firm tender offer 16.2% Open market repurchase 3.6% Targeted small holding 1.6% Calls of Non-Convertible Bonds -0.1%* Dividend Increases: Dividend initiation 3.7% Dividend increase 0.9% Specially designated dividend 2.1% Investment Increases 1.0% Implied Decrease in Corporate Cash Flow Security Sales Common stock - 1.6% Preferred stock 0.1%* Convertible preferred - 1.4% Straight debt -0.2%* Convertible debt -2.1% Dividend Decreases -3.6% Investment Decreases -1.1%
Smith (1993) Table 3 Pure Financial Structure Changes Type of Transaction Security Security 2-day AR Issued Retired Leverage-Increasing Stock Repurchase Debt Common 21.9% Exchange Offer Debt Common 14.0% Exchange Offer Preferred Common 8.3% Exchange Offer Debt Preferred 2.2% No Change in Leverage Exchange Offer Debt Debt 0.6%* Security Sale Debt Debt 0.2%* Leverage-Reducing Transactions Conversion-forcing Call Common Convertible -0.4% Conversion-forcing Call Common Preferred - 2.1% Security Sale Conv.Debt Conv.Bonds - 2.4% Exchange Offer Common Debt -2.6%
Smith (1993) Table 5 The Market Response to Announcement of Organizational and Ownership Changes Type of Announcement Cumulative Abnormal Returns Organizational Restructuring Merger: Target 20.0% Bidder 0.7%* Spin-Off 3.4% Sell-Off: Seller 0.7% Buyer 0.7% Going private 30.0% Voluntary liquidation 33.4% Ownership Restructuring Tender offer: Target 30.0% Bidder 0.8%* Large Block Acquisition 2.6% Secondary Distribution: Registered - 2.9% Non registered - 0.8% Targeted Share Repurchase - 4.8%
Alternative Methods of Marketing Security Offering Right offering Underwritten offering Private Placement Negotiated Competitive Monitoring Reputation of invest. bk Lower flotation costs Higher variance Confidentiality
Managerial Implications Issuing securities => negative reaction Why? Potential by management to exploit inside information by selling overvalued securities Investors recognize their vulnerabiltiy and reduce the firm s value Management implications Be sensitive to the way the market will interpret the announcement State clearly the intended uses for the funds Managerial opportunism may prove costly Investment bankers might make the issue more credible Look for ways to provide a credible signal (bonding)