Common stock offerings across the business cycle

Journal

of Empirical

Finance

1 (1993) 3-31. North-Holland

Common stock offerings across the business cycle” Theory and evidence Hyuk Choe The Pennsylvania State University, University Park. PA, USA

Ronald W. Masulis Vanderbilt University, NashviNe, TN, USA

Vikram Nanda University uf Southern California, Los Angeles. CA, USA Received

May 1992. Final version

accepted

October

1992

Abstract It is well known that historically a larger number of firms issue common stock and the proportion of external financing accounted for by equity is substantially higher in expansionary phases of the business cycle. We show that this phenomenon is consistent with firms selling seasoned equity when they face lower adverse selection costs, which occurs in periods with more promising investment opportunities and with less uncertainty about assets in place. Thus, firm announcements of equity issues are predicted to convey less adverse information about equity values in such periods. Empirically, we find evidence that generally supports these predictions. Consistent with historical patterns, firms in recent times have tended to increase equity more frequently in expansionary periods. While business cycle variables have significant explanatory power, interest rate variables are generally insignifi~nt. The adverse selection effects as measured by the average negative price reaction to seasoned common stock offering announcements is significantly lower in expansionary periods and in periods with a relatively larger volume ofequity financing. These offer announcement effects are less negative for smaller stock offerings and for issuers with less uncertainty about assets in place.

Correspondence to: Ronald W. Ma&is, Owen Graduate versity, 401 21st Avenue S., Nashville, TN 37203, USA.

School

of Management,

Vanderbilt

Uni-

*We would like to thank Yakov Amihud, Bhagwan Chowdhry, Harry DeAngelo, Stuart Gilson, Paul Malatesta, Jay Ritter, Ehud Ronn, Andrei Shleifer, Chester Spatt, Rene’ Stulz and Robert Vishny and workshop participants at the Australian Graduate School of Management, Duke University, Harvard University, The Securities and Exchange Commission, the University of British Columbia, University of Illinois at Urbana-Champaign, University of Maryland and session participants at the Western Finance Association Meetings, the American Finance Association Meetings, and the International Finance Conference sponsored by Groupe HEC, for useful discussions and comments. We would also like to thank Roger Ibbotson for giving us access to his monthly bond yield file. 0927-5398/93/$06.00

0

1993.--Elsevier

Science Publishers

B.V. All rights reserved

4

H. Choe et al.. Conmon

stock offerings

across the business cycle

1. Introduction The frequency of equity offers relative to debt offers has been documented by Hickman (1953) and Moore (1980) to increase in expansionary phases of the U.S. business cycle and decrease in the contractionary phases. Marsh (1982) and Taggart (1977) document that firms prefer to issue equity when equity prices are relatively high (which are typically periods of economic expansion) and to issue debt when debt prices are relatively high or interest rates are relatively low (typically periods of economic contraction). We show that these financing patterns can be explained theoretically by a time varying adverse selection effect faced by firms selling seasoned equity, where expansionary phases of the business cycle naturally induce weaker adverse selection effects. Following MyerssMajluf (1984), we view the managers’ efforts to maximize shareholder wealth by avoiding equity offers when the stock is substantially underpriced as the cause of the adverse selection effect. In contrast to the Myers-Majluf model which focuses exclusively on cross-sectional predictions of equity issues, our approach extends the analysis to debt issues and develops both time series and cross sectional predictions.’ In exploring the model’s comparative statics, we formally show that holding the moral hazard costs associated with debt financing fixed, relatively more firms will choose equity to debt financing in periods when more promising economic conditions for new investment exist and when uncertainty about assets in place is lessened. After verifying that the debt-equity issuance pattern across the business cycle has persisted in recent years, we subject the adverse selection explanation for this pattern of issuance activity to empirical evaluation relative to several competing explanations. A pooled cross sectional time series of common stock offers by relatively large U.S. corporations is used in this analysis where issue announcement period returns measure the adverse selection effect. We find that the relative frequency of monthly corporate equity to debt offers is positively related to expansionary phases of the business cycle and to stock price volatility. Unlike the earlier results of Marsh and Taggart, we do not find evidence of a significant interest rate effect. We do find evidence of a positive impact of prior stock market price changes on the frequency of equity and convertible debt offers relative to straight debt offers. Turning to the predicted adverse selection effect on stock prices of an announced equity offer, we first take into account the effects of issue characteristics which earlier studies by MasulissKorwar (1986) and Asquith-Mullins (1986) have documented to be significantly related to stock offer announcement period

‘Exceptions are Korajczyk-Lucas-McDonald (1990b, 1991) which explore the timing of equity offerings in relation to the release of annual and quarterly earnings reports and Lucas-McDonald (1990) which provides a dynamic model of equity issues. The relationship of these papers to ours is discussed below.

5

H. Char et al., Common stock offerings (across the business cycle

returns. Consistent with the predictions of our adverse selection model, we find that business cycle variables and monthly security issuance volume have significant incremental explanatory power in accounting for the magnitudes of excess announcement period stock returns, even after controlling for issue characteristics and interest rate changes. These results present new evidence supportive of an adverse selection effect in the equity issuance process. In a related paper, Lucas-McDonald (1990) provide a dynamic model of equity issuance that also involves an adverse selection effect. However, in their model firms do not have the option to finance projects using debt. As we discuss later, while the Lucas-McDonald model predicts that equity issues tend to follow a general rise in the market, it is quite different from ours and generates empirically distinguishable predictions. Unlike our model, the LucasMcDonald model does not predict any relation between stock market return, business cycle variables or stock issue activity and the stock price reaction to an equity issue announcement, once the pattern of stock returns prior to the issue announcement is taken into account.

2. Effect of adverse selection and changing investment opportunities on seasoned stock and debt offerings We begin by presenting a model in which firms can finance projects using either debt or equity. The model draws upon both the Myers-Majluf (1984) model of the adverse selection effect in equity financing as well as the Myers (1977) analysis of the agency costs of debt. In our model a firm’s financing choice is determined by the relative magnitudes of the adverse selection costs of equity, the agency costs of debt and flotation costs. The model is then used to generate empirical hypotheses about the firm’s choice of debt versus equity financing as a function of the investment environment and market uncertainty about firm assets in place. We assume that at time t = 1 there exists a set of publicly traded firms, each having a single liquidating payoff next period at t = 2. For simplicity the firms are assumed to be all equity financed to begin with. Investors are taken to be risk neutral and the risk free interest rate is taken to be zero. Firms are assumed to have no internal financing sources or ‘slack’ capital available.* If funds for new investments are needed, they must be raised externally by selling debt or equity. We assume that managers act in the best interests of current shareholders who are assumed to be passive investors, i.e., who do not alter their shareholding until the liquidation of the firm. We abstract from personal and corporate tax considerations.

‘Assuming that part of the investment could be funded through not affect the qualitative nature of our results.

internal

financing

sources would

6

H. Choe et al., Common stock offerings across the business cycle

At t = 2, the assets in place have a payoff V(i)+ A(0) where V(i) is a positive function of the firm’s type i and A(6) is a positive function of general economic conditions, t%[e, g], prevailing at t= 1. Only a firm’s manager observes the firm’s quality type. However, it is common knowledge that the range of firm types is ie[O, l] where higher i represents higher quality and the distribution of types i is represented by a continuous probability density function f(i) and cumulative density function F(i). The state of the economy 6 and, consequently, the value of A( 0) is common knowledge at t = 1. The firm’s terminal cashflows at t = 2 are publicly observable. At t = 1 it is common knowledge that each firm receives an identical profitable investment opportunity for which it needs to raise capital I.3 The payoff to the project is G(0) >I for all 8, i.e., the project has a positive net present value. G( 0) is taken to be increasing in 8. The project cannot be delayed so that if not undertaken at t = 1, the investment opportunity is lost. Each firm manager can engage in asset substitution actions that increase the variance of the firm’s terminal cashflows at a cost of a decrease in the firm’s expected value. If the firm chooses to finance its investment by issuing debt, managers have an incentive to resort to such an asset substitution due to the increased value of the default (put) option written by the bondholders to the stockholders.4 Specifically, we assume that the manager is able to raise the option’s value by increasing the variability of the firm’s joint cashflows from assets in place and its investment project so that its terminal cashflow at t = 2 increases to (( V(i) + A (Q))/z) + (G(e),%) - X with probability 71and decreases to zero with probability (1 - 7~).This cashflow variance increasing action involves an expected cost of nX in terms of a reduced end of period cashflow. Firms can engage in either debt or equity financing to raise I to fund the project, but they bear significant flotation costs CD for debt financing and CE for equity financing. These flotation costs are assumed to be sufficiently large to ensure that firms do not find it optimal to resort to a combination of debt and equity financing. If a firm resorts to debt financing, the debt contract will specify a fixed payment, Do,to be made on date t = 2. Since the amount of financing must cover I + CD, we know that Do 2I+ CD.However, once the debt has been

3The adverse selection effect in Myers-Majluf is primarily a consequence of information asymmetry about firm assets in place. The assumption that new investment opportunities are identical and observed publicly makes the exposition of the model considerably easier with little loss of economic intuition. For example, if it were to be assumed that new investment opportunities were not observable and positively correlated with the value of firm assets in place, the adverse selection effect would still exist and the qualitative nature of the results of the model would still hold. In particular it would still be the case that the more undervalued firms would face greater adverse selection costs in issuing equity and would be more likely to choose debt rather than equity financing for their projects, 4The incentive of manager-equityholders to increase the riskiness of the firm’s investments after the firm’s debt is issued has been extensively analyzed in the literature, starting with Fama-Miller (1972) Galai-Masulis (1976), Jensen-Meckling (1976) and Myers (1977).

H. Choe et al., Common

stock offerings across the business cycle

7

issued, the manager has an incentive to undertake an asset substitution to transfer wealth from bondholders to shareholders provided that the reduction in debt value is greater than the expected cost to shareholders of the asset substitution i.e., Do - nDo > rcX. Since Do 2 (I + C,), the manager will always engage in asset substitution provided that nX < (1 - rr)(Z + C,). We will assume that this condition holds. Given that investors will rationally anticipate asset substitution actions which imply a zero payoff with probability 1 -rc, the firm will be forced to issue debt with face value Do = (I + C,)/rt to be able to raise sufficient funds to finance the project. If a firm of type i undertakes the investment opportunity and finances it by issuing debt, then the market value of its equity will be (V(i)+ A(B)+ G(O)-Z - CD - TIX).~ Observe that if G(B) - I - CD - nX < 0, these firms will not find it profitable to use debt financing, preferring instead to either forgo the project or rely on equity financing. Since we are primarily interested in a firm’s financing choice, we assume that projects are sufficiently profitable so that G(8)- Z - CD- 7cX > 0, for all 8. Under this assumption no firm will find it optimal to pass up the investment project. When the project is financed with equity, let ~(0) be the fraction of the firm’s equity that must be sold to outside investors under economic state 8, so that Z + C, is raised. Let PE(0) be the market value of firm’s equity before the new equity offering is announced and let PE(0) be the market value of the equity following the offer announcement. By definition, we have the cash flow constraint: a(B)P,(e)=z+CE.

(1)

Any firm selling stock will find it optimal to raise Z + CE in equity financing. This follows since the market knows that firms with undervalued stock have no incentive to issue more equity than necessary to finance their projects, so firms with overvalued stock are also forced to issue the same quantity of stock to avoid revealing their lower quality to the market. A firm’s decision to use equity or debt financing will depend on how current shareholders’ wealth changes as a result of the firm’s financing choice. To analyze the equilibrium, let us begin by assuming that some firm types use equity to finance their investments, while other firms use debt. Let a firm of type i* be just indifferent between debt and equity financing in equilibrium. For such a marginal firm, the expected cash flows at t = 2 to current shareholders must be the same under an equity or debt financing decision which implies (1-a(B))[

V(i*)+A(B)+G(tl)]=

V(i*)+A(d)i-G(O)-Z-CD-xX.

(2)

5This follows since the firm is expected to engage in asset substitution. At t = 2, the equity will be worth (( V(i)+A(B)+G(B))/n)-DO-X with probability R and zero with probability 1 --s, where D,=(IfC,)/n.

8

H. Choe ef al., Common stock oferings

across the business cycle

The left hand side represents the portion (1 -U(B)) of the firm’s equity value retained by current shareholders while the right hand side represents the value of equity when debt financing is used. If such a marginal type i* exists, firms of type i>i* will prefer debt to equity financing, since these firm types are more undervalued than the marginal firm type. Similarly, firms of type i < i* will prefer equity to debt financing. Thus, in our model, unlike Myers-Majluf, the highest quality firms do not forego the investment project; they issue debt instead. Investor rationality requires that the equilibrium price PE(e) at which common stock can be sold will equal the expected value of the stock of firm types that choose equity financing in equilibrium, which is lower than that of the population of firms. Therefore, the market value of the equity is the average of the intrinsic values, P;(O), of all equity issuers. P,(t))=& Substituting simplifying,

F(Z*)

I-+-CE On rearranging

p:(e)

i=(J

i = i*

?‘(i)f(i)di+A(@+G(H)=-&

for ~((9) and PE(0) in equations we obtain:

z+7cx+cg

p

i=i* s

F(l*)

s i=CJ

Pi(tl)f(i)di

(1) and (3) into equation

(3) (2) and

P;(e) =- PE(O)’ (4) we obtain

Cz+CEl=z+CD+nX,

(4’)

E

where the marginal issuer’s equity has an intrinsic value of P:(O)= V(i*)+ A(O)+ G(0). The left hand side of (4’) can be interpreted as the equity issuance cost of the marginal firm where the ratio represents the adverse selection cost of selling shares for a market price of PE(0) when their true value is P:(O). The right hand side of (4’) represents the debt issuance cost. So (4’) is an alternative representation of the trade off between debt and equity financing faced by the marginal firm. It is apparent from equation (4’) that since Pg(l?)>P,(fl) (since I’(i*)>(l/F(i*)$:‘I’(i)f(i)d’) z , a necessary condition for any firm other than the lowest quality firm to issue equity in equilibrium is that [(I + C,)/(I + CD+ rrX)] < 1, i.e., the flotation and moral hazard costs of debt must exceed the issue costs of equity excluding adverse selection costs6 On the other hand, if debt issuance cost is so high that the right hand side of (4’) is always larger for any i*, then all firm types will resort to equity financing and

‘This is also a sufficient condition for equity issuance since the lowest firm type i = 0 does not face any adverse selection cost in issuing equity and would therefore always resort to equity financing if this condition was satisfied.

H. Choe er al., Common srock offerings acmu

9

the business cycle

there will be no new information about firm value associated with equity offering announcements. Instead, we will concern ourselves with the more general case in which there exists some firm i*e[O, l] such that equation (4’) is satisfied. We take the smallest i* that satisfies equation (4’) to be the equilibrium value of i*. Notice that at this equilibrium value of i*, the left hand side of (4’) is increasing in i*.7 Thus, all firms above i* will find debt cheaper to issue than equity while all firms below i* will find equity cheaper to issue. We turn next to the effects of changes in the general state of the economy, 0. As 8 increases, the left hand side of equation (4) is unaffected because investment size, flotation costs and moral hazard costs are assumed invariant to 8. However, since the effects of general economic conditions are assumed to affect all firms’ cash flows similarly, i.e., A(0) and G(B) are not firm specific, the right hand side of (4) decreases with 8 for a fixed i* since both the numerator and denominator are increasing by the same amount, but the numerator is larger. Also, since the right hand side of (4) is increasing in i*, it can only be satisfied as 8 increases, by raising i*. This means that as economic conditions improve and raise the value of assets in place and project payoffs, there will be a larger proportion of firm types choosing to issue equity. Investor rationality requires that the pre-announcement stock price PE(Q) must be a weighted average of the values of the firms that finance projects using equity and those that use debt (which represents all the firms receiving investment opportunities): i=l

p,(e)=(i

i = i’ + [s -F(i*))

[.I i=i*

V(i)f(i)di+A(8)+G(B)-Z-C,-7rX

V(i)j(i)di+A(8)+G(fl-I-C,

F(i*)

i=O

1.

1 (5)

As in Myers-Majluf, firms that announce an equity issue will be identified to be from the subset of lower types [0, i*] and, therefore, will be assessed to have a lower value than prior to the announcement. It is easy to verify that if the economic state 8 is better, the negative return at the announcement of an equity offering will be smaller. There are two reasons for this. One reason is that i* tends to increase as 8 increases, as shown above. This means that there is less adverse information revealed about the firm type at an equity announcement in a better economic state. The second reason is that the overall payoffs and values of the firm’s cashflows are increasing relative to the magnitude of the adverse selection effect. We can state these results as follows: ‘The reason why this must be true is that if i* =O, then there is no adverse selection and the right hand side of (4) is equal to 1. Since (I +zX + C,)/(1+ C,)> 1, we must have Pg(O)/P,(O) increasing in i* at the smallest value of i* that satisfies equation (4). If the left hand side is monotonically increasing in i*, then there exists a unique value of i* such that equation (4’) is satisfied.

10

H. Choe et al., Common stack offtirings actnw the business cycle

Proposition I. As the business conditions improve, i.e. 6 increases, holding everything else constant, a firm is more likely to issue equity rather than debt and the negative price reaction associated with an equity offering announcement

is smaller.

Since economic upturns are associated with periods having more profitable investment opportunities and greater values for assets in place, Proposition 1 can be interpreted as predicting that equity offers in economic upturns involve smaller adverse selection effects. In addition, across the business cycle a positive correlation is also predicted between stock offering announcement returns and aggregate equity offering frequency. The intuition here is that the more valuable the investment opportunity and assets in place, the more likely it is that a firm will be willing to bear the adverse selection costs associated with an equity issue. Since more types of firms will be willing to issue equity in periods with more profitable investment opportunities, it follows less adverse information is released by the announcement of a seasoned equity offering. We can also interpret Proposition 1 to predict cross sectionally that firms and industries with more profitable investments should exhibit less of an adverse selection effect and should be more likely to issue stock. The negative price reaction is further diminished by the greater likelihood of equity offers when the market previously knows that the firm has more profitable investment opportunities. Variation in factors other than the value of investment opportunities and assets in place through time will also affect both the number of firms issuing equity as well as the market’s reaction to an equity offering announcement. In our framework, an increase in uncertainty about the value of assets in place has similar implications for the equity issuance process as a decrease in 8. To see this consider the effect of a mean preserving spread on the distribution of V(i). The effect of the mean preserving spread will be to shift probability mass toward the tails, thereby decreasing (l/F(i*))~~*,O V(i)f(i)di for a given i* and raising the value of the ratio on the left hand side of equation (4’). Hence, the equilibrium value of i* satisfying (4’) will decrease. This follows since, as we saw above, the left hand side of (4’) is increasing in the value of i*. Since the equilibrium value of i* is decreasing, it can be shown that: Proposition 2. As market uncertainty over the value of a firm’s assets in place increases, holding everything else constant, the adverse selection efSect increases, so the number offirms issuing equity will decrease, the number ofjirms issuing debt will increase, while the negative price reaction associated with the equity offering announcement will be greater.’ sin our model the agency costs regarding the value of a firm’s assets ability to increase the riskiness of a between uncertainty about assets in

of debt are assumed to be independent of the uncertainty in place. Since the agency costs of debt arise from managerial firm’s cash Rows, it is not obvious what degree of correlation place and moral hazard costs of debt should exist.

H. Choe et al.. Common

stock offerings acron

the business c_vcle

11

Empirical research by Schwert (1989, especially Section III) on the determinants of stock market volatility ?ver the last 100 years documents that stock price volatility varies over the business cycle, increasing during recessions. Schwert links this volatility increase to increases in operating leverage; a condition which is to likely to be positively related to investor uncertainty regarding the value of firm assets in place. It follows that in economic downturns the uncertainty concerning the value of assets in place increases. Thus, we obtain the time series prediction that the adverse selection effect of an equity offer falls in economic upturns and rises in downturns due to changes in uncertainty about the value of assets in place. Proposition 2 can also be interpreted cross sectionally to predict larger adverse selection effects for firms and industries with greater uncertainty about assets in place. Several prior studies have found evidence supportive of this cross sectional version of Proposition 2 where several proxies for market uncertainty about the value of firm assets in place have been used including earnings variability, residual stock return variance, shareholder concentration, regulatory status and Tobin’s Q ratio.’ It is important to note that the predictions of Propositions 1 and 2 reinforce each other. In recessions, the adverse selection effect rises because the profitability of new investment falls while uncertainty concerning the value of assets in place rises.

3. Alternative explanations for the effect of business conditions on the equity issue process To credibly evaluate the importance of the adverse selection hypothesis Hl in the equity issuance process, we consider the descriptive power of several competing theories to account for the corporate financing variables examined here. While there are many theories of the equity decision process that are consistent with at least some of the existing evidence, we focus on alternatives that have attracted significant interest in the corporate finance literature which have time series predictions. These competing hypotheses and their predictions are discussed below. (H2): Security OfSeer Timing: Debt and Equity Securities are Issued When Their Respective Market Values are Relatively High: This hypothesis argues that equity is issued when the risky market discount rate is especially low (reflecting especially low equity risk premiums) or when expected profits are especially high which causes stock prices to be relatively high. In contrast, debt is issued when nominal interest rates are especially low (due to relatively low real interest rates) which cause bond prices to be relatively high. In part, this positive interest rate effect on debt issuance activity can reflect increased debt refinancing ‘For (1990).

example,

see Dierkens

(1991), Eckbc+Masulis

(1992) and Korajczyk-LucasPMcDonald

when interest rates fall. This hypothesis is motivated by the prior empirical work of Marsh and Taggart and the observation that corporate managers desire to time security offerings to minimize the firm’s cost of capital. An empirical prediction of this hypothesis is that there are relatively more equity issues following stock market price rises and more debt issues following interest rate reductions. No clear predictions concerning stock price reactions to security offering announcements are implied. (H3): Wealth Redistributions Across Security Classes This hypothesis posits that issuing equity lowers firm leverage, thereby reducing debtholder risk. Though a loss in equity value may occur, agency problems between managers and shareholders could motivate managers to take actions of this type. Managers with considerable specific human capital invested in the firm are likely to be more risk averse than shareholders and may prefer to reduce the possibility of the bankruptcy, despite the resulting loss in equity value. Thus, unexpected reductions in financial leverage should increase debt prices and lower the value of the equity, as residual claimant. lo Since this effect should increase with initial leverage and the riskiness of firm assets, equity offers should have larger positive effects on debt prices and equally larger negative effects on stock prices in downturns where higher debtholder riskbearing exists. These wealth transfers between debt and equity holders will also induce a relative preference for equity issues in economic upturns since the magnitude of the wealth transfer from equity to debt holders is smaller in periods when debt is less risky, which are generally periods when firm asset values are rising. Several additional cross sectional predictions can be obtained from this hypothesis. Equity offering announcement effects should be more negative for firms with larger leverage changes, and larger earnings volatility. Also bond prices should exhibit positive announcement effects and the dollar changes in bond prices should be of equal size to that of stock prices at the announcement of equity offers. When stock price volatility rises, the risk (H4): Flotation Cost Hypothesis of security offer failure rises as does the resulting expected cost. This expected cost effect should be greatest for the firm’s riskier securities, namely its common stock and convertible securities. Since underwriters must charge fees to cover their expected losses, flotation costs of equity offers should rise relative to straight debt offers as market volatility rises. l1 This shift in the relative cost of equity issuance should cause the relative frequency of equity offers to fall as stock price variability rises, if managers seeking to maximize current “See Galai-Masulis (1976) and Jensen-Meckling hypothesis and Masulis (1980) for some supportive

(1976) for more extensive empirical evidence.

discussions

of this

“Many studies have found that common stock flotation costs and underwriter spreads are positively related to stock price variability, see for example Bagat-Marr-Thompson (1985) and Eckbo-Masulis (1992). This phenomenon reflects the higher expected costs to the underwriter which must ultimately be borne by the issuer.

13

I

Table Predictions

of alternative

(HI J:

Adwrse

hypotheses

.srlection

(1) (2)

Increased frequency of equity offers relative to debt offers in economic upturns. Smaller negative stock price reactions to equity offers in economic upturns.

(1) (2)

Increased Increased

(HZ):

frequency frequency

(H3):

(1)

1:;

Wealth

qjf>r timing

redistrihutums

across security

classes

Increased frequency of equity offers in economic upturns. Less negative stock price reactions to equity offers in economic upturns. Less positive straight debt price reactions to equity offers in economic upturns. iH4~:

(1)

Security

of equity offers after stock price rises. of debt offers after interest rate falls.

Increased

frequency

of equity

Flotation

cost hypothesis

offers when stock market

volatility

drops

shareholder wealth base their security issuance decisions in part on the relative cost of issuing alternative instruments.” A summary of the empirical predictions of our four hypotheses is presented in table 1.

4. Empirical evidence on the timing of equity issues Earlier studies of U.S. corporate financing behavior by Hickman (1953) for the 1900-1938 period and Moore (1980) for the 194661970 period find that the ratio of stock to bond financing typically increased in the growth phases of the business cycle (i.e., trough to peak) and decreased in the contractionary phases. Using this evidence as a starting point, we first document that firms with stock listed on the NYSE, AMEX, and NASDAQ over the 1971-1991 period exhibit a similar significant variation in the dollar amount of common stock to debt

“It is tempting to posit an additional hypothesis based on an optimal leverage model which trades off the expected tax benefits and expected distress costs of debt across the business cycle. This hypothesis would predict increased debt offers in economic upturns and increased stock offers in downturns since the expected tax benefits fall while the expected distress costs rise in downturns. However, this prediction is clearly inconsistent with our initial evidence as well as the earlier work of Hickman (1953) and Moore (1980). Furthermore, security issuance activity is a very crude way to measure leverage changes since it excludes stock repurchases, bond redemptions, private placements. changes in bank debt and trade credit. maturing debt. the exercise of convertible securities and stock options, stock financed acquisitions and changes in the market values of outstanding financial claims, all of which change a firm’s financial leverage.

14

H. Choe et al., Common

stock oflerings across the business cycle

issued across the business cycle. l3 We expand on the earlier evidence by jointly estimating the impacts of interest rate changes along with business cycle measures. We also expand on the earlier work by controlling for the effects of changes in stock price levels and volatility and interest rate levels, which could independently influence the debt-equity financing decision under hypotheses H2-H4. Having documented the robustness of the previously observed debt-equity financing patterns, we examine how security price reactions to equity offering announcements are affected by issue characteristics and economic conditions. If an adverse selection effect is the cause of the typically negative stock price reactions to equity offering announcements, then these price changes should be cross sectionally related to measures of asymmetric information such as phases of the business cycle, project profitability, offering size and market uncertainty concerning the value of assets in place, which has been proxied by shareholder concentration, Tobin’s Q ratio and regulatory status. We investigate issue characteristics and phases of the business cycle in relation to observed adverse selection effects while taking into account the impacts of changes in interest rates and stock market conditions. We examine the marginal impact of the aggregate debt-equity offering frequency on the adverse selection effects experienced at the individual stock level.

4.1. Data Our first data set covers public offers of all seasoned primary common stock, convertible and non-convertible debt offerings by NYSE, AMEX and NASDAQ listed firms over the 1971L1991 period. The data is comprised of 5694 common stock issues, 1324 convertible debt issues and 6439 straight debt issues.14 To obtain the number and dollar volume of common stock and debt issues for each month, we used the Registered Offering Statistics (ROS) data base provided by the Securities and Exchange Commission.’ 5 We consider only firms listed in the stock files of the Center for Research in Security Prices (CRSP) at the University of Chicago.16 ‘%nce CRSP’s NASDAQ file begins December 14, 1972, we have treated any 1971-72 common stock offers by firms with stock listed on NASDAQ as of the end of 1972 as NASDAQ stock offers and the population of NASDAQ stocks in the 1971-72 period as the number initially listed on the CRSP file. 14The offering dates instead of the filing dates, are used in section 4.2, since the ROS data base contains only offering haies for offerings prior to 1976. IsSince the cusip numbers in the ROS data are not reliable, and in fact are often missing, each record is verified and correlated based on the company names on the CRSP stock files. If multiple records are registered simultaneously for the same category of issue for a firm, they are counted as one, but the amounts are summed. 16The 1990 versions of the CRSP daily stock return files for NYSE/AMEX is used.

and NASDAQ

listings

Our stock offering announcement data set covers the 196331983 period and consists of 669 seasoned primary offerings of common stock by industrial firms and 787 offerings by public utility firms listed on the NYSE or the AMEX at their announcement date. Several business cycle variables including the monthly indices of leading and coincident indicators and of industrial production were obtained from the Citibase data file. Bond yields for various rating classes are obtained from Ibbotson (1985). The dates of business cycle peaks and troughs are determined by the NBER and are regularly provided in issues of the U.S. Department of Commerce Business Conditions Digest. Initial announcements of seasoned, underwritten common stock offerings as well as other salient characteristics of the issue and issuer, for the 196331980 period were obtained from a revised version of the MasulissKorwar (1986) data set of NYSE/AMEX offerings;” offerings information for the 1981-1983 period was obtained from the Wull Street Journal Index, Dow Jones News Retriecal Service, Drexel, Burnham, Lambert’s annual Public Oflerings qf Corporute Securities, the ROS file and offering prospectuses. Regulated utility offerings are separately analyzed since these offerings may be driven by different factors than the typical industrial firm.18 In general, utility offerings are much more frequent and predictable and are less likely to be associated with adverse selection given the extensive regulation of industry profits and frequent regulatory pressure to undertake equity offerings.

4.2. Relatior .f~equerzc~y qf’ quit?* issues mross

the business c?‘cle

We begin with an overview of security issuance activity across the business cycle. We classify expansionary phases and contractionary phases of the business cycle using the dates of cycle peaks and troughs as identified by the NBER as the boundary points of these phases. To control for the fact that the population of potential issuers varies over time and possibly across phases of the business cycle, the number of security offerings per month is scaled by the number of firms listed on the NYSE, AMEX and NASDAQ at that time. This measures the proportion of listed firms making security offers per month. Table 2 provides data on the average frequency of common stock, convertible bond and non-convertible bond offerings over business cycle upturns and downturns. Since convertible bonds can be viewed as a delayed common stock offering, we have separately analyzed convertible and non-convertible bond offers. Over the 1971-1991 sample period, the U.S. economy experienced four upturns and downturns. In comparing frequencies of security types across “For

details of the sample

“Regulators public interest

selection

procedure.

refer to Masulis-Korwar.

may have different incentives than firm managers responsibility and their own political status.

and shareholders

because

of their

16

H. Choe et ul., Common .stock ofltirings awos.s the business cycle Table 2” Common

Business cycle

Period

Mean

stock Mean

Convertible Mean

debt Mean

Non-con. Mean

debt Mean

A. Meanfiequencies ofcommon stock and debt oJ%nys per year by N YSE, AMEX and NASDAQ listed companies categorixd by phases of the business cycle owr the 1973-3991 period Upturns Downturns

All Months All Months

NUM 280.59 238.07

FRAC 4.88 4.10

NUM 70.22 37.93

FRAC 1.19 0.66

NUM 281.63 394.50

FRAC 4.13 6.59

Upturn Downturn Upturn Downturn Upturn Downturn Upturn Downturn

71/01-73;11 73/l 2-75103 75/04-80,‘Ol 80102%80/‘07 80/O&8 1107 81/08-82,/l I 82,‘12-90;/06 90:07-9 I ,‘12

278.12 99.00 185.17 296.00 467.00 280.50 317.35 304.67

4.96 1.83 3.60 5.9 I 8.98 5.08 5.12 4.64

64.94 6.75 23.38 56.00 124.00 60.00 94.70 40.00

1.17 0.12 0.46 1.12 2.40 I .09 1.50 0.61

197.29 224.25 201.52 278.00 208.00 279.00 312.65 687.33

3.53 4.16 3.91 5.55 4.02 5.05 5.79 IO.46

B. Mean dollar volumes ofcommotz stock and deht ojjerinys pu year by N YSE, AMEX and NASDAQ listed companies categorized by phases of the business cycle owr the 1971-3991 period Upturns Downturns

All Months All Months

VOL 10,262 10,268

AVOL 12,447 10.110

VOL 3,880” 3,195

AVOL 4,346 2,942

VOL 32,043 45,574

AVOL 35,143 44,786

Upturn Downturn Upturn Downturn Upturn Downturn Upturn Downturn

71/01-73/l 1 73/12-75;‘03 75’04480/O I 80.02280/07 80108-8 l/O7 8 I/08-82!’ 11 82,!12-90/06 90/07-91/12

5,678 3.223 6,217 10.03 1 13,892 8,744 13,995 17,965

13,528 6.524 10,276 12.404 15,861 9,134 12,971 13,400

2,047 357 853 3,783 5,555 2,613 6,247 6.04 I

4,940 719 1,430 4,653 6,378 2.738 5,699 4,529

10,297 19,506 15,504 29,341 19,341 26,192 52,163 91,384

24,705 39,145 25,395 35,905 22,310 27,254 46,821 68,344

“We measure upturns from trough to peak in the business cycle and downturns from peak to trough where troughs and peaks are classified by the NBER. The fraction of firms with primary security offers (FRAC) is constructed from the monthly number of security offerings (NUM) divided by the total number of firms traded on NYSE, AMEX and NASDAQ for each month, and multiplied by 100. Adjusted dollar volume (AVOL) is constructed as the dollar volume of security offerings (VOL) scaled by the CPI (100 at July, 1983) to produce a constant dollar volume figure. The unit of dollar volume measure is millions. The data source is the Securities and Exchange Commission’s ROS data base. Preferred stock and initial public offerings, secondary offerings, rights offerings and private placement of common stock are excluded.

phases of the business cycle, we find that firms have a greater propensity to issue common stock and convertible bonds in economic expansions and non-convertible bonds in economic contractions.” These data are also consistent with the earlier evidence of Hickman (1953) and Moore (1980) who studied corporate ‘“Exceptions to this stated pattern are the very short contraction in early 1980 when stock offers did not fall but were followed by a large rise in the subsequent upturn, the 198221990 upturn when significant increases in nonconvertible debt were issued, though the subsequent downturn witnessed

financing patterns over the 1900-1938 and 1946-1970 periods respectively. We also find that the annual frequencies of common stock and convertible bond offers are much more variable over the phases of the business cycle than are non-convertible bond offers. These data are supportive of predictions of hypotheses HlLH4, but do not distinguish among these alternatives.

4.3. Regression

analysis

qf the relative frequency

of stock to bond c@ers

One major limitation of the above evidence is that it only reports the average frequencies of security offerings for two broad phases of the business cycle, expansionary and contractionary periods, so that is doesn’t take into account differences in the magnitudes or durations of the economic upturns and downturns as measured by stock market and interest rate conditions. We next wish to study the question of how these security financing patterns are related to more detailed measures of the economy’s existing business conditions which can affect the security offering decision. We analyze the frequency of public offers of common stock relative to bonds and use the data to test important predictions of Hl and H2. In Hl, equity issuance is more costly in economic downturns while debt issuance costs are relatively insensitive to the business cycle. In contrast, H2 predicts that more debt is issued in periods when interest rates have fallen while more equity is issued in periods when stock prices have risen. To test the above predictions, we need to take into account firms’ diminished demand for external capital in economic downturns. Thus, rather’than examining changes in debt and equity issuance separately across the business cycle, we examine the frequency of equity offers relative to all security offers. This ratio is defined as the market values of public offers of common stock relative to common stock and all bonds sold per month. Alternatively, we measure this ratio by the market values of public offers of common stock and convertible bonds to common stock and all bonds sold per month. This ratio is measured monthly to control for the fact that contractions on average represent shorter time spans than expansions. To separately test the predictions of our Hl and H2, we use a multiple regression framework where the relative frequency of equity issuance is regressed against changes in major business cycle variables as well as changes in stock market prices and long term and short term interest rates. Stock price volatility is also included as an explanatory variable to capture the potential

much greater debt issuance, and a high volume of equity in the 199G1991 downturn highly leveraged firms issued significant amounts of stock to recapitalize at historically leverage ratios.

when several more typical

negative impact on equity issuance activity of market uncertainty about the value of the firm’s assets predicted by Proposition 2 and to test the prediction of H4 that stock offer activity is negatively related to stock market volatility. Current changes in economic conditions are measured by growth rates of indices of leading economic indicators, coincident economic indicators and industrial production as well as the change in monthly spreads of Moody’s AAA rated and below BAA rated corporate bonds, where all four variables are measured over the three months prior to the stock offering. These business cycle variables are included to capture the effects of both decreased investment profitability and the increased uncertainty about the values of assets in place that are associated with business cycle downturns. All the explanatory variables are measured over the three months preceding the offering announcement on the presumption that this information is likely to influence managers’ security issuance decisions. The linear regression model is estimated using monthly data over the 1971-1991 period. However, because the residuals from the initial estimation exhibited strong first order serial correlation, we reestimated the model using the Cochrane-Orcutt procedure. The results are reported in table 3. All the explanatory variables used in the estimation are defined at the bottom of the table. In general, we find that changes in long term or short term interest rates have only a small positive but statistically insignificant effect on the relative frequency of equity offers. These results differ from prior studies by Marsh and Taggart that report a positive influence of interest rate changes and prior stock market price changes on equity issuance and a negative influence of interest rate changes on debt issuance. In contrast, we find that neither the stock market runup nor the interest rate changes have significant explanatory power once business cycle and stock volatility measures are included in the analysis. The various time series measures of asymmetric information have consistently significant parameter estimates of the predicted sign. The relative frequency of equity offers is diminished by stock market volatility and increased by most business cycle measures such as the growth rate of industrial production or the index of leading indicators (one exception is the change in yield spread which is predicted to have a negative impact). The explanatory power of this time series model is relatively good, with adjusted R’s ranging from 29 to 35 percent. The evidence of significant business cycle and stock market volatility effects is consistent with the existence of an adverse selection effect posited by Hl. The positive but generally insignificant coefficients on the prior stock market runup and interest rate changes are weakly consistent with the predictions of the security offer timing hypothesis H2. Lastly, the negative coefficient on stock market volatility is also consistent with H4. The model is also estimated where the dependent variable is defined as the ratio of the market value of common stock and convertible bond issues to all common stock and bond issues per month. The rationale for this alternative

19

H. Chop rt ul., Common stock offerings across the business cycle Table 3 Estimates

of the monthly ratio of common stock issues to all security issues in dollar NYSE, AMEX and NASDAQ listed companies (1971-1991)” ERAT=a,+cc,AlNTl

+azAINT2+a,

BUS (1) (2) (3) ASPR (4) GLEADX (5) GLEADX (6) GCOINX (7) GIPX (8) ASPR (9) GLEADX (10) GLEADX (11) GCOINX (12) GIPX (13) ASPR (14) GLEADX (15) GLEADX (16) GCOINX (17) GIPX

26.433 (14.4) 26.407 (14.4) 27.791 (15.5) 24.129 (15.2) 24.810 (15.0) 25.449 (14.8) 25.379 (14.6) 24.657 (15.1) 22.547 (15.8) 22.611 (15.6) 22.476 (14.6) 22.414 (14.5) 27.976 (14.5) 25.017 (14.6) 25.139 (14.4) 25.322 (13.9) 25.221 (13.8)

1.528 (0.9)

a3

a4

~ 3.010

0.007 (0.0) 0.027 (0.1)

- 2.919

1.033 (1.4)

(- 3.0)

0.786 (1.1)

-3.175 (-3.5) - 2.268 (-2.5) -2.338 ( - 2.6) -2.991 (- 3.4) - 2.903 (-3.3)

0.476 (0.3) 0.220 (0.1) 2.492 (1.4) 1.593 (0.9) 0.855 (1.1) 1.469 (0.8) 1.123 (0.6) 1.485 (0.8) 0.950 (0.5) 0.633 (0.8) 0.658 (0.3) 0.417 (0.2)

for

VOLAT+z,MRUNUP+a5BUS+&

( - 3.0)

1.604 (1.0) 1.392 (0.9)

volume

- 3.276 (-3.2) - 2.503 (- 2.6) - 2.527 (- 2.6) - 2.885 (- 2.9) - 2.785 (-2.8)

0.188 (1.3) 0.057 (0.4) 0.070 (0.5) 0.207 (1.6) 0.205 (1.6) - 0.039 (- 0.2) - 0.09 1 (-0.6) -0.074 (-0.5) 0.020 (0.1) 0.024 (0.1)

0.34 0.35 - 27.544 (- 1.6) 1.473 (3.0) 1.409 (2.9) 1.913 (2.8) 1.446 (2.3) - 19.842 (- 1.1) 1.712 (3.4) 1.641 (3.2) 1.956 (2.9) 1.582 (2.5) -28.170 (- 1.6) 1.558 (3.1) 1.485 (2.9) 1.901 (2.8) 1.457 (2.3)

0.34 0.36 0.36 0.36 0.36 0.31 0.35 0.35 0.34 0.34 0.34 0.36 0.37 0.36 0.36

‘T-values are presented in the parentheses. The Cochrane-Orcutt method is used to adjust for the first order autocorrelation ERAT is the ratio of common stock issues to the sum of common stock, convertible and straight bond issues in dollar volume per month. BUS represents business cycle variables. MRUNUP is the continuously compounded market returns over the 60 trading days prior to the beginning of the month of the stock offering. Value-weighted CRSP index is used as a proxy for the market index. VOLAT is the daily market return variance measured over the 60 trading days prior to the beginning of the month of the stock offering. ASPR is the change in monthly yield spreads between lower grade (lower than BAA) corporate bonds and Moody’s AAA-rated corporate bonds measured over three months prior to the month of the stock offering. GLEADX, GCOINX and GIPX are respectively the logarithmic growth rates of the indices of leading economic indicators, coincident economic indicators and industrial production for three months prior to the month of the stock offering. AINTl is the change in monthly interest rates on long-term (10 years or more) government bonds measured over three months prior to the month of the stock offering. AINT2 is the change in monthly interest rates on 6-month commercial paper measured over three months prior to the month of the stock offering. All variables are in percentages.

20

Estimates

of the monthly ratio of common stock and convertible bond issues to all security dollar volume for NYSE. AMEX and NASDAQ listed companies (197ll1991).” ECRAT=ao+a,AINTI

(1) (2) (3) ASPR (4) GLEADX (5) GLEADX (6) GCOINX (7) GIPX (8) ASPR (9) GLEADX (10) GLEADX (1 I) GCOINX (12) GIPX (13) ASPR (14) GLEADX (I 5) GLEADX

(I 6) GCOINX (17) GIPX

32.685 (15.6) 32.610 (15.7) 35.528 (16.7) 31.583 (I 7.0) 31.677 (16.8) 32.902 (16.1) 32.537 (15.8) 31.350 (16.6) 28.823 (17.8) 28.880 (17.5) 28.888 (16.3) 28.580 (16.1) 34.405 (15.5) 3 1.047 (15.9) 3 I .065 (15.8) 3 I .496 (15.1) 31.101 (14.9)

+aZAINT2+a,

1.846 (0.9)

VOLAT+r4MRUNUP+c(,BUS+c

- 2.750

( - 2.4) 1.361 (1.6)

(~ 2.4)

0.473 (0.6)

-3.710 (-3.5) ~ 2.569 (-2.5) -2.619 (-2.6) -3.561 (-3.5) -3.437 (-3.4)

0.670 (0.3) 0.299 (0.1)

- 0.603 (-0.3) - I .249 (- 0.6) 2.665 (1.3) I .542 (0.8)

- 2.680

1.008 (1.2) 1.573 (0.8) 0.848 (0.4) 1.769 (0.9) 0.995 (0.5) 0.822 (1.0) 0.846 (0.4) 0.224 (0.1)

issues in

-3.019 (-2.6) ~ 2.204 (- 2.0) -2.186 (~ 2.0) -2.651 ( ~ 2.4) -2.514 (-2.2)

0.37

0.270 (1.6) 0.303 (1.9)

0.424 (2.7) 0.268 (1.7) 0.293 (1.9) 0.452 (3.1) 0.448 (3.1) 0.215 (1.2) 0.138 (0.8) 0.168 (1.0) 0.282 (1.7) 0.286 (1.8)

0.37 - 29.233 (- I .5) 2.125 (3.9) 2.072 (3.7) 2.120 (2.7) 1.989 (2.8) ~ 16.964 (-0.8) 2.130 (3.8) 2.035 (3.5) 2.148 (2.8) 2.096 (3.0) ~ 24.120 (- 1.2) 1.998 (3.5) I .903 (3.3) 2.105 (2.7) 1.995 (2.8)

0.36 0.39 0.39 0.38 0.38 0.34 0.38 0.39 0.37 0.37 0.36 0.39 0.40 0.39 0.39

a T-values are presented in the parentheses. The CochraneeOrcutt method is used to adjust for the first order autocorrelation ECRAT is the ratio of common stock and convertible bond issues to the sum of common stock, convertible and straight bond issues in dollar volume per month. BUS represents business cycle variables. MRUNUP is the continuously compounded market returns over the 60 trading days prior to the beginning of the month of the stock offering. Value-weighted CRSP index is used as a proxy for the market index. VOLAT is the daily market return variance measured over the 60 trading days prior to the beginning of the month of the stock offering. ASPR is the change in monthly yield spreads between lower grade (lower than BAA) corporate bonds and Moody’s AAA-rated corporate bonds measured over three months prior to the month of the stock offering. GLEADX, GCOINX and GIPX are respectively the logarithmic growth rates of the indices of leading economic indicators, coincident economic indicators and industrial production for three months prior to the month of the stock offering. AINTl is the change in monthly interest rates on long-term (10 years or more) government bonds measured over three months prior to the month of the stock offering. AINTZ is the change in monthly interest rates on 6-month commercial paper measured over three months prior to the month of the stock offering. All variables are in percentages.

dependent variable is that the convertible debt issues are effectively delayed equity issues and as such are likely to be issued in a similar fashion. Consistent with this view, surveys of corporate executives such as Hoffmeister (1977) indicate that the primary motive for issuing convertibles is as a delayed equity offering. The results of this estimation are presented in table 4. Again, a CochraneOrcutt adjustment is necessary. The estimates yield results similar to table 3, though several of the variables are marginally more significant. Specifically, the parameter estimate for stock market runup with and without the inclusion of other business cycle variables is more significant than in table 3. As in the prior table, all the business cycle variables with the exception of yield spread are statistically significant and all exhibit their predicted signs. The coefficients of determination range from 32% to 35% which is similar to table 3. The positive relation between the relative equity issuance activity and the growth rate of leading indicators as predicted by the adverse selection hypothesis Hl is further documented in fig. 1. These ratios exhibit a consistent pattern of rising in expansionary periods and declining in contractionary periods, which is similar to the earlier Hickman and Moore findings.

ECRAT(%)

GLEAD(%)

loollo

80 -

60 -

40

20

-

O+-

70

72

74

76

78

80

82

84

86

88

90

92

YEAR

Fig. I. Ratio of common stock and convertible bond issues to the sum of common stock, convertible and straight bond issues in dollar volume (ECRAT: needles) and three month growth rate of the index of leading economic indicators (GLEAD; line graph) for each month over the 1971-1991 period.

22

H. Choe et ul., Common

stock offerings c~cross the business cycle

The time series pattern in the relative frequency of equity to debt financing across the business cycle could be affected by time series patterns in the refinancing of debt by firms. However, this refinancing effect should primarily be captured by our interest rate change variables rather than our business cycle variables. As discussed above, the regression estimates are not supportive of a significant interest rate effect.

4.4. Measuring returns

the adverse selection @ects of common stock announcement

To estimate the abnormal stock price reaction to announcements of underwritten common stock offerings, we follow conventional event study methodology. For each firm in the sample, a one-factor market model was estimated over 150 trading days beginning 10 trading days after the initial offering announcement.” The market return was defined as the value-weighted continuously compounded daily return2’ on the NYSE and AMEX index obtained from the CRSP market index file. In table 5 we report the average abnormal returns for our industrial utility samples of common stock offerings over event days (- 5,5), where event day 0 is defined as the initial announcement date if known or otherwise the day prior to the WSJ publication date. The average abnormal returns for industrial and utility issuers over the announcement period, event days (0, l), are -2.62% and -0.75% with 77% and 67% of the samples exhibiting negative returns. These results are comparable to those reported in earlier studies such as Masulis and Korwar (1986) Asquith and Mullins (1986) and Barclay and Litzenberger (1988). For the purposes of estimating our cross-sectional regressions, we use the abnormal return over the two day event window (0, 1).22 We evaluate the cross sectional relationship of stock market reactions to equity offering announcements with business cycle variables as well as firm specific measures of adverse selection. Earlier studies of equity offer announcements by Masulis-Korwar (1986), Asquith-Mullins (1986), Korajczyk-LucasMcDonald (1990, 199 l), Bayless-Chaplinsky (1991), Dierkens (1991) and Pilotte

“‘We eliminated “These

returns

sample

points

that did not have at least 100 valid observations.

are logs of price relatives

at the close of each trading

day.

“Studies of stock return behavior have indicated the presence of a January seasonal in stock returns. Previous research has documented systematic differences in stock return behavior on different days of the week, and especially on Monday and in different months, especially the end of quarters. These facts led us to examine our sample for the frequency of announcements across the months of the year and days of the week so as to assess whether seasonalities in returns were a significant factor in the observed cross-sectional variation of stock price responses to those announcements. For all partitions, the abnormal returns are significantly negative. The results appear to indicate the absence of systematic monthly or day of the week patterns.

23

Average abnormal seasoned common

daily common stock returns surrounding stock offerings by NYSE and AMEX period.” Industrial

0 I 2 3 4 5 CAR(-1.0) CAR(0, I) CAR(-1, I)

(N = 669)

Public utilities (N = 787)

(T)

AR<0 (o/u)

- 0.02 0.03 0.16 0.05 -0.53 ~ 1.89 -0.73 0.04 0.11 0.15 0.26

(-0.17) 0.28) (1.73) (0.51 (- 5.55) (- 15.02) (-6.53) (0.45) (1.23) (1.63) (2.96)

52.3 51.3 49.8 52.5 59.5 73.4 60.1 50.2 49.6 47.2 46.0

- 0.02 0.00 0.02 -0.09 - 0.08 - 0.44 -0.30 -0.11 -0.07 0.00 -0.07

(-0.40) (0.03) (0.3 1) - 1.85) - 1.68) - 8.30) - 5.52) ~ 2.08) 1- 1.51) (0.09) (- 1.34)

51.6 50.4 51.5 54.3 52.9 63.5 57.8 52.9 52.6 50.7 50.4

-2.42 - 2.62 -3.15

( - 16.07) (- 16.41) (- 17.68)

75.0 76.5 77.7

-0.52 - 0.75 -0.82

(-7.89) (- 10.00) (-10.11)

64.3 66.5 67.6

Event day -5 -4 -3 -2 -1

firms

initial announcements of underwritten listed companies over the 1963-1983

(T)

AR<0 (Oh)

“AR is the one day continuously compounded abnormal return averaged cross-sectionally. Abnormal returns for individual firms are measured using a one-factor market model, where the market return is proxied by the CRSP equally-weighted index and the parameters are estimated by OLS over event days (1 I, 160). CAR(t, T) represents the cross-sectional average of abnormal returns continuously compounded over event days (t. T). T-values are presented in the parentheses.

(1992) found that various issue characteristics had explanatory power in cross sectional regressions of stock offer announcement period returns. A number of these issue characteristics have an adverse selection interpretation as discussed earlier. To assess the marginal explanatory power of business cycle variables, we included most of these same issue characteristics as additional regressors in our statistical model. Furthermore, we control for the potential effects of bond and stock price changes, as predicted by the security offer timing hypothesis H2, by including these variables as additional regressors. Cross sectional regressions were estimated using firms’ abnormal announcement period stock returns as the regressand and issue specific characteristics, interest rate changes, stock market volatility and business cycle variables as regressors. Weighted least squares (WLS) was used since the residuals from ordinary least square estimation exhibited serious heteroskedasticity. The weighting factor used in these WLS estimates is the reciprocal of the time series standard deviation of the individual stock’s daily return over the 7.5 trading days prior to the equity offer announcement.23 ‘jThis was found to be a better weighting factor than log of equity capitalization and is consistent with price reactions by stocks with lower price volatility representing more reliable information events.

The predicted signs and interpretations of the explanatory variables are as follows. The percentage change in shares outstanding, hereafter ASHR, is included to capture the higher adverse selection effect caused by larger offers, which is predicted by the Krasker (1986) extension of the Myers-Majluf model. We measure ASHR by the logarithm of shares issued divided by shares previously outstanding and expect to observe a negative parameter estimate. The leverage decrease induced by the stock issue is predicted to shift wealth from stockholders to bondholders as firm default risk is lowered according to the security holder wealth redistribution hypothesis H3. Therefore, the larger the leverage decrease, the greater the negative stock price reaction to the announcement, which implies a positive parameter estimate. As shareholder concentration increases, closer monitoring of the firm and its managers becomes optimal for major shareholders. This should lower the asymmetric information between management and outsider shareholders, which lowers the negative price reaction to equity offerings. This is measured by the market value of the stock prior to the announcement divided by the number of shareholders. According to the Lucas-McDonald model, the pre-announcement price runup should be negatively correlated with the adverse selection effect of an equity offer. The preannouncement stock price runup also implies that firm leverage is falling which should lower the likelihood that an equity offering would be undertaken according to standard optimal capital structure models. Thus, an equity offering is likely to convey more negative information about firm value in this case.24 The stock price runup is measured over the 75 trading days prior to the offer announcement.*’ A number of macroeconomic variables are used to help explain the equity offer pricing effects.*(j Changes in the interest rates on six month commercial paper and ten year Treasury Bonds are included to capture the effects of bond issuance being preferred to stock when interest rates have fallen, a pattern documented in prior studies and predicted by the security offer timing hypothesis H2. The runup in the stock market index over the 75 trading days prior to the stock issue announcement can be interpreted as a revision in the market forecast

24Eckbo-Masulis (1991) document that seasoned common stock issues sold by right offer, a method which can lessen or eliminate the adverse selection effect according to MyerssMajluf, on average do not exhibit a positive stock price runup effect. 25KorajczykPLucassMcDonald (1989) document that the sign of the stock runup variable is sensitive to the length of the runup period chosen. When a runup period encompassing the 250 to 500 trading days prior to the offer is chosen, the coefficient is significantly positive rather than negative. This is consistent with management’s current superior information about the firm’s value having a limited life of less than a year which causes the adverse selection effect to dissipate. At the same time, this is a long enough period to ensure that the associated positive investment opportunity announcements will also be captured in the runup variable. 26We also examined our sample for evidence of seasonal behavior in the frequency or in the magnitude of announcement stock price effects. The results indicated systematic monthly or day of the week patterns.

ofequity issues the absence of

of the economy’s position in the business cycle.27 The greater the gain in the stock market index, the smaller the adverse selection effect. Thus, a positive parameter estimate is predicted. Lastly, we consider several standard measures of the current phase of the business cycle. These business cycle variables include: yield spread of AAA and below BAA corporate bonds, growth rates of leading and coincident indicators, growth rate of industrial production, and measures of relative frequency of equity offers. Except for yield spread, these variables are positively correlated with the phase of the business cycle and so are predicted to have positive parameter estimates. Table 6 presents the results of estimating this cross sectional regression separately for industrial (Panel A) and utility issuers (Panel B).” The first regression in Panel A uses only firm specific explanatory variables and shows statistically significant parameter estimates consistent with the adverse selection hypothesis. Specifically, share change and share price runup are significantly negative and shareholder concentration and market price runup are significantly positive as predicted. Introducing interest rate changes in regressions (2))(3) does not improve the model specification. There is also a significant negative estimate for leverage change which is inconsistent with the securityholder wealth redistribution hypothesis H3. In regressions (4)-(9) several stock market and business cycle variables are included as additional variables. Since the announcement of a common stock issue typically precedes by several weeks the actual issue, the relevant variables that a manager would consider in making a stock offer are the recent changes in the firm’s debt and equity prices. From an investment perspective, it should be the future prospects of the economy that determine the level of funds raised. We approximate this forecasting process by several alternative measures: the recent runup of a stock market index, the change in interest rates of ten year and six month corporate debt instruments, the yield spread between high and low rated corporate bonds and several business cycle variables, all measured over the three months prior to the offering. The business cycle variables that we use are the index of leading indicators, the index of coincident indicators and the index of industrial production. We measure the logarithmic growth rates of these indices over the three months preceding the stock offering. Overall, the results for the industrial offerings indicate that larger market runups, decreases in yield spreads, larger 3 month growth rates in the indices of leading indicators and coincident indicators as well as the index of industrial production are associated with smaller negative stock returns on the

“See Fama (1981) for evidence that the stock market economic activity.

makes unbiased

forecasts

of subsequent

real

“Utility issuers were defined to be regulated power, water, gas transmission, and telephone companies. We explored whether telephone companies were better characterized as industrial firms and concluded that this was not the case.

(15) ECRAT

(14) ERAT

(13) VOL

(12) ECRAT

(11) ERAT

(10) VOL

(9) GIPX

(8) GCOINX

(7) GLEADX

(6) ASPR

(5)

(4)

(3)

(2)

(1)

BUS

WLS estimates

Table 6

(-0.4) -0.214 (- 1.0) -0.271 (-1.3) 0.025 (0.1) -0.067 (-0.3) -0.123 (-0.6)

-0.033 (-4.6) -0.037 (-4.3) -0.032 ( - 4.0) ~ 0.032 ( ~ 3.9) -0.033 (-3.8) ~ 0.030 (- 3.4) -0.031 (- 3.6) - 0.043 (-4.3) - 0.042 (-4.2) - 0.043 (-4.2)

0.706 (4.0) 0.696 (4.1) 0.712 (4.2) 0.705 (4.1) 0.649 (3.6) 0.712 (3.9) 0.690 (3.8) 0.662 (3.6) 0.715 (4.0) 0.697 (3.8)

-0.705 (-2.5) -0.635 (-2.3) - 0.677 (-2.5) -0.686 (-2.5) -0.667 (- 2.4) -0.705 (~ 2.6) -0.701 (-2.5) -0.656 (- 2.4) -0.686 (-2.5) -0.684 (-2.5)

~ 0.498 (- 1.8) -0.460 (-1.7) -0.481 (~ 1.8) -0.488 (- 1.8) - 0.443 (-1.6) -0.428 (-1.5) - 0.427 (-1.5)

- 0.400 (- 1.4) -0.382 (-1.3) -0.384 (- 1.4)

- 18.6 (-6.2) - 15.6 (~ 5.3) - 15.4 (~ 5.3)

(-0.8) - 0.073

- 0.024 (-0.1) -0.128 (-0.6) -0.200 ( - 0.9) -0.186

0.010 (0.1)

~ 15.7 ( - 5.6) - 15.4 (-5.7) - 15.7 (-5.7) -15.6 (-5.7) - 19.1 (-6.3) - 15.4 (-5.2) - 15.1 (-5.2)

-0.105 (-0.5)

0.692 (4.1) 0.700 (4.1) 0.706 (4.1) 0.678 (4.0) 0.689 (4.0)

-0.729 (-2.7) -0.717 (-2.7) -0.722 (-2.7) -0.680 (-2.5) -0.676 (-2.5)

- 0.530 ( ~ 2.0) -0.508 ( ~ 2.0) -0.506 (-1.9) -0.472 (-1.8) -0.457 (- 1.7)

- 15.4 (-5.7) - 15.5 (-5.7) - 15.6 (-5.7) - 15.2 (- 5.6) - 15.4 (-5.6)

-0.031 (-3.9) -0.032 (-3.9) -0.032 (- 3.9) ~ 0.044 (-4.6) ~ 0.044 (-4.5) - 0.050 (-0.6)

-0.077 (-0.9)

0.046 (2.0) 0.054 (2.4) 0.050 (2.2)

0.050 (2.4) 0.048 (2.3)

0.548 (2.5) 0.356 (1.4) 0.430 (1.9)

(2.4)

-5.41 (-1.7) 0.098 (1.8) 0.103 (1.3) 0.066 (0.9) 0.658 (3.1) 0.465 (1.9) 0.543

8.5 8.3

0.075 0.073

8.3 7.7 7.9

0.088 0.091

8.4

0.084 0.095

8.0

0.079

9.0

8.7 0.077

0.090

8.7

9.2

9.2

9.9

0.077

0.082

0.08 I

0.075

9.8

0.074

F

12.2

R2

stock offering

0.075

of NYSE and AMEX listed stocks’ continuously compounded abnormal returns over the two day seasoned common announcement period regressed on issue anb issuer characteristics and business cycle variables (1963%1983).”

1.31 (0.8) 1.34 (0.8) 1.46 (0.9) 1.45 (0.9) 1.57 (0.8) I .64 (0.9) 1.78 (0.9)

(1)

(6) ASPR

(-0.1)

-0.014

PI.21 (-2.4) -1.18 ( ~ 2.4) -1.11 (-2.2) - 1.14 (-2.3) - I .24 (-2.5)- 1.19 (-2.3) _ 1.23 ( - 2.4)

-1.21 (-2.2) -1.19 (-2.4) -1.21 (-2.4) Pt.18 (-2.3) ~ 1.20 (-2.4) -0.123 (-1.2) -0.121 (-1.2) -0.129 (-1.2) -0.129 (-1.2) -0.159 (- 1.4) -0.150 (-1.3) -0.154 (- 1.4)

- 0.048 (-5.6) - 0.042 (-4.9) -0.047 (- 5.6) -0.047 (-5.5) - 0.047 (-5.3) -0.046 (- 5.2) ~ 0.046 (-5.3)

- 0.047 (-5.5) -0.047 (-5.5) - 0.047 (-5.5) -0.046 (-4.9) - 0.046 ( ~ 4.9) -0.234 (-2.2) -0.213 (-2.0) -0.196 (- 1.8) -0.205 (-1.8) ~ 0.239 (-2.2) -0.224 (-2.1) -0.238 ( - 2.2)

-0.241 (-2.3)

~ 0.237 (-2.2) -0.238 (-2.3)

B. Public utilitirs iN = 748) -0.136 (- 1.2) -0.131 (-1.3) -0.124 (- 1.2) -0.131 (-1.3) -0.124 (-1.2) -0.098

-0.098 (-2.2)

( - 2.2) -0.002 (-0.2) -0.001 (-0.1)

(3)

- 1.85 (-1.2) - 0.064 (~ 2.6) - 0.044 (-1.3) -0.027 (-0.9) 0.045 (0.4) -0.119 (-1.1) -0.019 (- 0.2)

7.7 7.6 8.0 9.0 8.0 7.8 7.4 7.6 7.3

0.042 0.045 0.05 1 0.045 0.044 0.044 0.045 0.043

9.5

9.6

7.7

0.043

0.044

0.044

0.043

“T-values are presented in the parentheses. BUS represents business cycle variables such as GLEADX, GCOINX, GIPX, ASPR and measures of volume of equity issues for the month of the common stock offering date. ASHR is the log ratio of number of shares issued over outstanding shares. CON is the logarithm of market value of stocks divided by the number of shareholders. ALE V is the change in debt-equity ratio due to the offering, where debt is measured as the book value and equity is measured as the market ofcommon stock. AINTI is the change in monthly interest rates on long-term (10 years or more) government bonds measured over three months prior to the month of the stock offering. AlNT2 is the change in monthly interest rates on 6.monlh commercial paper measured over three months prior to the month of the stock offering. RUNUP and MRUNUP are the continuously compounded individual stock returns and market returns over the 75 trading days prior to the announcement date. Value-weighted CRSP index is used as a proxy for the market index. GLEADX, GCOINX and GIPX are respectively the logarithmic growth rates of the indices of leading economic indicators, coincident economic indicators and industrial production for three months prior to the month of the stock offering. ASPR is the change in monthly yield spreads between lower grade (lower than BAA) corporate bonds and Moody’s AAA-rated corporate bonds measured over three months prior to the month of the stock offering. VOL is the logarithm of dollar volume of common stock issues measured over the month of the stock offering. ERAT is the ratio of common stock issues to the sum of common stock, convertible and straight bond issues in dollar volume per month. ECRAT is the ratio of common stock and convertible bond issues to the sum of common stock. convertible and straight bond issues in dollar volume per month.

(12) ECRAT

(11) ERAT

(10) VOL

(9) GIPX

(8) GCOINX

(7) GLEADX

(5)

(4)

(3)

(2)

I .49 (0.9) 1.45 (0.9) 1.33 (0.8) 1.46 (0.8) 1.33 (0.8)

announcements of stock offerings. These results are consistent with the predictions that price reactions to equity offering announcements should be less negative in periods in which the economic prospects for the near future are good.” Next we directly examine the relation between abnormal stock returns and the relative volume of common stock issues around the time of the offering announcement. The prediction of the adverse selection hypothesis Hl is that periods with relatively greater equity issue volume should also be periods with smaller negative price reactions to equity offering announcements. We use three measures of relative equity issue volume: the two ratios studied in tables 3 and 4 as well as the logarithm of dollar volume of common stock measured over the month of the equity offering. The data on security issue volume is derived from the SEC’s ROS database which provides the public offering dates of the security issues but not their announcement dates. The typical delay between the announcement date and the actual issue date by our 669 stock offerings by industrial issuers indicates that the median time interval is on average 25 calendar days. This suggests that a reasonable proxy for the aggregate volume of common stock unnouncmrnts in the month is the actual volume of common stock issues sold in the subsequent month. Regressions (lo)-( 15) present the results of using these measures of relative equity issue volume as alternative measures of the expected adverse selection effect associated with these stock issues. They exhibit positive parameter values as predicted and are generally statistically significant, even when market runup is also included in the regressions. These regression estimates indicate that relative equity offering volume is equally effective at capturing the varying degree of adverse selection present at equity issue announcements. The regression results for the utility sample are presented on table 6, Panel B. They indicate a much weaker adverse selection effect with stock runup being the only statistically significant parameter estimate. These regression estimates find no significant relation between announcement returns and business cycle variables with the exception of the growth rate of leading indicators. However, these results are consistent with regulated utilities manifesting minimal adverse selection risk at the time of equity announcements. In contrast to the industrial offerings, the interest rate variables are negative and significant for the utilities, suggesting that the market reacts less positively to utility stock issue announcements when interest rates are falling, which are times when the cost of capital for issuing bonds is lower. Also, there is a significant negative parameter estimate for leverage change which is inconsistent with the security holder wealth transfer hypothesis H3. Our evidence is also consistent with several predictions of the LucasMcDonald adverse selection model. Their model predicts that equity offers are 29The evidence reported in Pilotte (1992) that stock announcement returns are positively to measures of firm growth rates is further evidence in favor of Proposition 1.

related

H. Char et al., Common stock offerings

across the business qclr

29

more likely after a stock price runup. They argue that if stock price rises across firms are correlated, then their model predicts that the frequency of equity issues will tend to rise following a general rise in the stock market, which is consistent with our evidence. Second, their model predicts that firms with greater prior stock price rises will experience larger negative stock price reactions to stock offer announcements. This prediction is consistent with the significant negative regression coefficient observed for the stock price runup variable. However, this supportive evidence should be tempered by the following observations. First, their model has no predictions for the frequency of bond offerings. Second, their model makes no predictions that the asymmetric information between the manager and outside investors varies across time. Thus, their model cannot explain the significant regression coefficients for the various business cycle variables, the prior stock market rise or the equity issue volume, once the stock’s own prior price runup is accounted for.

4.5. Evidence on ultrrnative

hJ)ppotheses

We now review the evidence concerning the competing hypotheses explaining the equity issuance decision. Previous empirical evidence on the equity issue decision supportive of the security offer timing hypothesis H2 has been documented in Taggart, and Marsh. They report that stock issues are positively correlated with general stock market gains as well as issuer stock price rises, while bond issues are positively correlated with interest rate decreases (i.e., bond price rises). In our empirical analysis, however, we find that changes in the short and long term interest rates have little influence on the equity issuance decision. Also, neither long term nor short term interest rates have any significant power to explain stock offer announcement price reactions. However, prior stock market price increases are found to be positively related to the frequency of equity issues. Also the evidence is supportive of a negative relation between stock market volatility and stock offer frequency, as predicted by H4. Several of the predictions of the security holder wealth transfer hypothesis H3 appear to be generally consistent with the empirical evidence. The frequency of stock issues rises in economic upturns, while the announcement effects are less negative. The main drawback with the wealth redistribution hypothesis is that the cross sectional regressions exhibit a positive relation between stock announcement period returns and the leverage change induced by the stock issue, contrary to the prediction of the hypothesis. In addition, bond prices do not experience positive price effects of a similar magnitude to the negative effect experienced by stock prices on stock offer announcements. In fact, KalayyShimrat (1987) report evidence for industrial issuers of negative average announcement effects for both straight and convertible debt. Therefore, while the wealth redistribution effect may be present to some degree, it appears to be

dominated by negative information effects. In conclusion, these competing hypotheses cannot by themselves account for all the empirical evidence presented, however, it is possible that these factors do affect the equity issuance process in a manner complementary with the adverse selection effect.

5. Conclusion This paper extends the earlier tests of an adverse selection effect in the equity issuance process by extending the Myers-Majluf model to allow for debt issuance and by formally developing both time series and cross sectional predictions. We then subject these predictions to empirical verification. The adverse selection effect of equity offerings is predicted to decrease when more promising economic conditions for new investments exist. Consequently, the average abnormal negative return associated with equity offering announcements is predicted to be smaller in these periods. Larger adverse selection effects are also predicted when the uncertainty concerning the value of firm assets in place increases. By testing this broader set of predictions while controlling for interest rate changes, we subject the adverse selection model of the equity issuance process to more rigorous examination than have previous studies. Consistent with the predictions of our extension of the Myers-Majluf adverse selection model, we find that the monthly relative frequency of public offers of common stock relative to bonds measured in market value terms is significantly positively associated with prior stock market returns and various business cycle variables. The effect of interest rate changes, reported in earlier studies, is insignificant in explaining the relative frequency of equity offerings and in explaining cross sectional equity offer announcement returns. Our data also indicate that, after controlling for issue characteristics and interest rate change variables found to have significant explanatory power in earlier studies, business cycle variables have significant incremental explanatory power in accounting for the magnitudes of the excess announcement period stock returns. Furthermore, the relative volume of equity issues in the announcement month is significantly positively related to announcement period stock returns. These findings are consistent with the adverse selection model’s prediction that periods of economic growth are associated with both greater volumes of equity issues as well as lower adverse selection costs. Consistent with the predictions of the Lucas-McDonald adverse selection model, the prior stock price runup is significantly negatively related to the market’s price reaction to the equity offering announcement. It is also noteworthy that several other issue characteristics remain statistically significant such as leverage change and shareholder concentration. These other explanatory variables also have an adverse selection interpretation and their parameter estimates are qualitatively consistent with this interpretation.

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