Valuation effects of corporate debt offerings

Journal

of Financial

Economics

VALUATION

15 (1986) 119-151.

North-Holland

EFFECTS OF CORPORATE

DEBT OFFERINGS

B. Espen ECKBO* University of Britwh Columbiu, Vancouver, B.C., Canada V6T I Y8 Received

February

1985, final version received July 1985

This paper analyzes the effect of corporate debt offerings on stock prices. Straight debt offerings have non-positive price effects, while convertible debt offerings have significantly negative effects. Public utility mortgage (non-convertible) bond offerings have marginally negative effects, and the effect is significantly negative when the proceeds are used to finance the utility’s investment program. Cross-sectional regressions reveal no relation between offer-induced price effects and offering size, rating, post-offer changes in abnormal earnings or debt-related tax shields. The evidence is inconsistent with theories predicting that the price etTects of capital structure changes go in the direction of the leverage change.

1. Introduction

and summary

There is substantial evidence that firms’ capital structure changes convey new information to investors and therefore affect stock prices. As reviewed by Dann and Mikkelson (1984) the available evidence prior to their own study collectively documents a positive relation between the direction of the leverage change and the sign of the revaluation of equity. For example, Masulis (1980) finds that firms offering to exchange debt for common stock on average experience a statistically significant increase of 9.79% in the stock price over the two trading days preceding and including the day of the first announcement of the offer in the financial press. Dann (1981) and Vermaelen (1981) both find positive average abnormal returns exceeding 14.00% over the same two-day interval when firms announce offers to repurchase common stock. McConnell and Schlarbaum (1981) document a two-day average announcement period return of 2.18% in response to exchange offers involving income bonds for preferred stock. In contrast, increasing the firm’s equity position seems to convey negative information: Asquith and Mullins (1986) and Masulis and Korwar (1986) find statistically significant average two-day announcement period returns of -3.22% and -3.0% in response to the issuance of *I want to thank Paul Asquith, Sanjai Bhagat, Michael Jensen, Wayne Mikkelson, Merton Miller, Ieuan Morgan, Stewart Myers, Ronald Rogers. Cliff Smith. Joseph Zechner. Gailen Hite (the referee). and the participants of the UBC finance workshop and the University of Rochester MERC Conference on Investment Banking and the Capital Acquisition Process for their helpful comments.

0304-405X/86/$3.5001986,

Elsevier Science Publishers

B.V. (North-Holland)

120

B. E. Eckho, Valuation effects of corporaie debt oferrngs

seasoned common stock by industrial firms. Furthermore, Mikkelson (1981) reports that firms announcing convertible debt calls, effectively forcing conversion of the debt into common stock, on average experience negative returns of - 2.13% over the two-day announcement period. However, Dann and Mikkelson (1984) find evidence of negative average two-day abnormal returns of -2.31% also when firms issue convertible debt. This is consistent with the earlier evidence only under the assumption that the typical convertible debt issue effectively decreases the financial leverage of the issuing firm, an assumption the authors claim is not descriptive of their sample. Furthermore, Dann and Mikkelson document a marginally significant, negative valuation effect of straight debt offerings. In their sample of 150 straight debt issues, the average two-day announcement period return is -0.37%, with a t-value of - 1.76. They explore several possible explanations for the anomalous evidence but arrive at no completely satisfactory explanation. Thus, while the evidence strongly supports the proposition that leveragedecreasing capital structure changes convey negative information to the market, the valuation effects of capital structure changes which increase leverage is an unresolved empirical issue. In this paper I provide new evidence on the market reaction to more than seven hundred corporate debt offerings, most of which are straight debt. The primary objective is to test the conventional view that there is a positive relation between a leverage-increasing capital structure change and the sign of the revaluation of equity. The sample firms all substantially increased their leverage position in the years when the debt was offered, which supports the underlying assumption that the individual debt announcements conveyed leverage-increasing information to the market. Based on the predictions of competing capital structure theories, I specify cross-sectional regressions relating the announcement-induced abnormal stock returns to various characteristics of the debt offering and the issuing firm, including the size of the issue, the risk of the bonds, estimates of the increase in the issuing firm’s debt-related tax shield, and indicator variables capturing the effect of alternative uses of the external financing (such as refunding and financing of the firm’s investment program). I also examine to what extent the abnormal returns aggregated over all debt offerings in the sample by a given firm in a given year can be explained by subsequent unexpected changes in annual earnings, a topic which has generally been ignored by previous empirical studies in this area.’ Since, by the standards of the literature, the debt issues examined in this paper are large (on average $181 mill. for the industrial companies), and given that the sample captures more than two thirds of UN debt offerings per firm in a given sample year, the analysis of the correlation between abnormal stock price and earnings behavior is particularly informative. ‘An exception is Vermaelen common stock repurchases.

(1981) who examines

unexpected

changes

in earnings

following

B. E. Eckho, Valuation efects of corporate debt offerqs

121

I find no evidence that the issuance of debt, whether straight or convertible, on average conveys positive information to the market. Thus, the evidence does not give support to theories of optimal capital structure where the tax advantage of debt is balanced against agency costs, costs of financial distress, information costs or other debt-related costs, such as in Kraus and Litzenberger (1973) Jensen and Meckling (1976) Ross (1977). DeAngelo and Masulis (1980) and Heinkel (1982). Assuming value-maximizing behavior, and abstracting from issue-related transaction costs, this class of ‘relevance’ theories generally implies that an unexpected increase in leverage will cause a positive revaluation of the issuing firm’s common stock. The cross-sectional regressions fail to uncover a significantly positive correlation between announcement period abnormal returns and the tax shield and earnings variables. Furthermore, the results give only partial support to models which imply that the announcement of any unanticipated external financing, whether through stocks or bonds, will cause a reduction in firm value. For example, in Miller and Rock (1985) a larger-than-expected external financing reveals a lower-than-expected operating cash flow, which is negative news to investors. Thus, the Miller and Rock model implies a negative stock price effect of an unanticipated debt issue as well as a negative correlation between the price effect and the amount of unanticipated new financing. While I find significantly negative average abnormal returns to firms offering convertible debt, straight debt offerings are, with the exception of a subsample of public utility offerings, on average associated with zero abnormal performance. Furthermore, there is no evidence that the price effect depends on the amount offered, which contradicts the Miller and Rock prediction to the extent that offering size is a reasonable proxy for the amount of unanticipated new financing. The difference between the market’s reaction to straight debt vs. equity issues is broadly consistent with the Myers and Majluf (1984) model. In their framework, the market reacts negatively to an unanticipated external financing as relatively uninformed investors account for the possibility that the firm is attempting to take advantage of a situation in which it knows the security offered is priced above its ‘intrinsic’ value. However, I detect no significant correlation between the abnormal return caused by a straight debt offering and the risk of the bonds, where risk is measured using Mocdy’s ratings and the pre-issue leverage ratio of the firm. Unless the straight bonds in the sample are essentially riskless (despite Moody’s rating of a significant portion of the sample as ‘low-quality’), this result is somewhat difficult to square with the model of Myers and Majluf. The empirical evidence also fails to reject the proposition that preemptive rights offerings and underwritten offerings convey identical signals to the market concerning the value of the issuing firm’s shares, a result which is of some relevance to the Myers and Majluf framework. The rest of the paper is organized as follows. Section 2 describes the potential determinants of the stock price effect of a bond issue and gives a broad outline of the paper’s basic test strategy. Section 3 gives the sample

12

B. E. Eckho, Vuluution effects of corporate debt offerrugc

design and data sources, section 4. The empirical concludes the paper.

while the estimation results are analysed

methodology is discussed in in section 5, while section 6

2. Potential valuation effects of a debt offering 2.1. Hypotheses

and predictions

Under the ‘irrelevance’ theories of Modigliani and Miller (1958) and Miller (1977), which imply that capital structure per se has no intrinsic value, the announcement of a ‘pure’ capital structure change will leave the issuing firm’s market value unchanged. A ‘pure’ capital structure change is one which does not alter the market’s perception of the issuing firm’s real asset composition or investment policy. In the presence of simultaneous changes in these factors, a debt offering can have a non-zero impact on the issuing firm’s common stock even if the irrelevance proposition is correct. In this case any observed valuation effect necessarily reflects factors outside the irrelevance theory, such as issue transaction costs and the capitalized value of new investment opportunities which are revealed to the market simultaneously with the debt offering. In the following, the Modigliani and Miller prediction is referred to as the ‘zero impact hypothesis’. An alternative class of capital structure theories implies that the firm’s stock price will change in response to news of a debt offering per se, even in the absence of factors such as issue transaction costs and capitalization of new valuable investment opportunities. Typically, the firm is assumed to trade off a corporate tax advantage of debt against costs of financial distress [Kraus and Litzenberger (1973), Brennan and Schwartz (1978), DeAngelo and Masulis (19801, or against the agency costs and adverse managerial incentive effects of debt [Myers (1977)]. In Jensen and Meckling (1976) the firm reaches an optimal capital structure by balancing the agency costs of debt against agency costs of equity.2 As a result, the market interprets news of a debt offering as a signal that the company’s capacity to extract debt-related benefits has increased. Furthermore, in the presence of incomplete protective bond covenants, arising from non-negligible costs of financial contracting, an unanticipated issue of debt can lead to a transfer of wealth from existing senior security-holders to the issuing firm’s stockholders [Galai and Masulis (1976). Smith and Warner (1979)]. I collectively refer to these predictions as the ‘positive impact hypothesis’. A third class of capital structure models, which draw in particular on the work of Akerlof (1970) and Spence (1973), share the implication of the positive impact hy-pothesis. These models rely on information asymmetries - rather *In the framework of Jensen and Meckling (1976). the firm’s optimal combination equity does not presuppose the existence of a corporate tax-advantage to debt.

of debt and

than taxes and agency costs - to justify a unique optimal leverage ratio. Managers are assumed to possess superior information relative to investors concerning the intrinsic value of the firm. Under the further assumption that it is prohibitively costly for relatively low-value firms to mimic the financial decisions of relatively high-value firms, these models imply that firms’ capital structure choices lead investors to accurately distinguish low-value from highvalue firms [Ross (1977), Leland and Pyle (1977), Heinkel (1982)]. In the context of this paper, an unanticipated increase in financial leverage signals positive management expectations concerning the firm’s future earnings prospects, thus causing a positive revaluation of the firm’s shares. The opposite prediction follows from the asymmetric information models developed by Miller and Rock (1985) and Myers and Majluf (1984). Assuming the firm’s investment opportunities are known, Miller and Rock present a model where a larger-than-expected external financing reveals a lower-thanexpected operating cash flow, which constitutes negative news to investors. Myers and Majluf, on the other hand, generate a negative market reaction to a firm’s external financing by arguing that relatively uninformed purchasers of the firm’s security will demand a discount in order to hedge against the risk that the security is ‘overvalued’. Both models imply that relatively high-value firms will pass up a valuable investment project if the project cannot be financed out of current earnings, and if the expected drop in the share price in response to the news of the external financing outweighs the project’s net present value. The Miller and Rock model predicts a negative correlation between the (negative) stock price effect and the unanticipated amount of new debt offered, while the Myers and Majluf model suggests that the riskier the security issued, the greater the issues’ (negative) impact on the market value of the frm.3 I collectively refer to these predictions as the ‘negative impact hypothesis’. 2.2. Empirical test strategy In order to distinguish between the zero, positive and negative impact hypotheses, the cross-sectional average abnormal return associated with debt offerings is examined. Furthermore, the average abnormal return tests are ‘The latter prediction is not entirely within their model as ‘[We] have not been able to procc that this positive relationship is always monotonic’ [Myers and Majluf (1984, n. 25)]. It does follow. however, that the Myer and Majluf firm is always better off issuing risk-free than risky securrties [risk being the elasticity of the security’s market value with respect to changes in firm value due to firm-specitic (i.e., diversitiable) factors] since the information asymmetry in their model concerns the firm’s future investment activity. The Miller and Rock model does not imply such a distinction since their information asymmetry extends only to the return on past investments. The Myers and Majluf model underlies Myer’s (1984) presidential address, where he suggests a ‘pecking order’ theory of finance, under which firms prefer internal to external financing, and, when external financing becomes necessary, the firm issues the least risky securities (such as low-risk debt) first. Some evidence in support of this scenario can be found in Donaldson’s (1961) study of the financing practices of large corporations.

124

B. E. Eckho,

Valuation

efecis

of corpomte

debt offerings

complemented with estimates of the cross-sectional relation between the abnormal return and its potential determinants, as suggested by the theories referred to above. Thus, to gain additional perspective on the zero impact hypothesis, an attempt is made to control for the confounding effects of transaction costs and capitalization of the value of new investment opportunities by including the underwriter spread in the cross-sectional regressions, and by isolating the sample debt offerings where the proceeds from the issue are used for the purpose of refunding old debt. Second, with reference to the positive impact hypothesis, the cross-sectional regressions include estimates of the tax shield implied by the new debt issue, as well as estimates of the abnormal change in earnings (before interest and taxes) in the period immediately following the offering. If there is an earnings-related information effect of the offering which goes beyond the implied increase in the firm’s expected tax shield, then both variables should appear with statistically significant coefficjents. Third, the regressions include the size of the debt offering and a measure of the bonds’ default risk in order to address more fully the Miller and Rock and Myers and Majluf predictions. Furthermore, results based on underwritten offerings are contrasted with results based on debt sold through preemptive rights given to the issuing firm’s shareholders. A basic premise of the Myers and Majluf framework is that the value of the original issue discount (relative to the intrinsic value of the security issued) is transferred from current shareholders to outside investors. As pointed out by the authors, a rights offering which leads current shareholders to purchase and hold the new issue, violates this basic premise. 3. Data sources and sample design The 723 corporate following procedure:

debt offerings

in the data base were selected

using

the

(1) Produce a list of all firms on the 1982 Standard and Poor’s Annual Industrial Compustat (Expanded Primary, Supplementary and Tertiary) files which, for any given year during the period 1964 through 1981, increased or decreased their long-term debt by more than a threshold amount. This threshold is set to $50 mill. in 1964 and increased by 5% a year to $114 mill. in 1981.4 The resulting list contains a total of 1915 firms. 4The choice of a $50 mill. limit in the base year 1964 reflects the objective of focusing on a relatively large sample of relatively large debt offerings, and was decided upon after studying the frequency distribution of the number of firms changing their debt under alternative size limits Note that all references to debt on the Compurtut tape are in terms of book values. The 1982 Expanded Primary, Supplementary and Tertiary Industrial Compustat files contain a total of 2395 companies including the firms in the Standard and Poor’s 500 Index, some of the firms in the 40 Utilities Index. the 20 Transportation Index. the 40 Financial Index, plus a number of other companies listed on the New York and American Stock Exchange.

B. E. Eckbo, Valuation effects of corporate debt offerings

125

(2) For

each firm on the list, use the Wall Street Journal Index for the relevant year to identify every announced debt offering of a size greater than or equal to that year’s long-term debt change threshold. This yields a total of 1023 debt offerings. Furthermore, to be included in the sample, the Wall Street Journal Index must indicate that (a) the debt instrument is a bond, a note or a debenture (which excludes 91 offerings classified as certificates, bank loans, credit line, or simply as ‘debt’), (b) the debt is offered on the domestic capital market (which excludes 20 overseas issues), and (c) the issue is not part of an exchange offer involving other securities of the firm (which excludes 11 cases). Finally, exclude an issue if the firm, according to step (1) above, either decreased its long-term debt or if, according to the Compustat, the sum of the changes in the firm’s short-term and long-term debt is less than the year’s debt limit (which excludes another 89 offerings).5 date given in the Wall (3) Exclude debt offerings where the announcement Street Journal Index cannot be confirmed by reading the Wall Street Journal itself, as well as offerings where the Wall Street Journal article announces an equity offering jointly with the firm’s debt issue (excludes 90 debt issues). In sum, the sampling procedure results in a complete history of all debt offerings made by firms on the 1982 Compustat tape which increased their long-term debt by a minimum amount (with no offsetting reduction in shortterm liabilities), and where the size and nature of the debt instrument (as defined above) were mentioned in the Wall Street Journal. Table 1 shows there were a total of 723 such issues over the 18-year sample period, of which 497 were made by industrial firms and 226 by public utilities (as defined by Compustat). The 723 offerings were made by 216 firms (176 industrials and 40 utilities), with an average of 32 different firms per year over the sample period. The typical firm in the sample issues bonds in 2.7 of the 18 sample years, each year offering on average 1.3 sample issues of debt.6 The average size of the ‘Thus. steps (1) and (2) produce only 89 debt oiTerings where the firm either decreased their long-term debt or where the sum of the year’s increase in long-term debt was substantially offset by a decrease in the firm’s short-term liabilities. For the 813 debt offerines which remain in the sample after step (1) and (2), the net increase in the firms’ long-term debt and sum of long- and short-term liabilities both exceed the year’s debt limit. Finally, note that when repeating step (2) for debt decreases, the procedure results in only 41 announced debt retirements. Thus, given the first two steps of the sampling procedure, in a typical year the ratio of the number of annual debt issues to the number of debt retirements is approximately 45 to 2. 6The utilities recur with a higher frequency than the industrials: a public utility is on average represented in 4.8 of the sample years, each year offering on average 1.2 issues of debt. Also, note that the firms in my sample had a total of 1056 debt offerings announced in the Wall Street Journal over the sample period (counting only the years when a firm had at least one issue qualifying for inclusion in the sample). Thus, the sample captures on average 68% of a// announced offerings made by the firms in the relevant years, and, due to the minimum size limit, a much greater proportion of the total dollar amount raised through new debt.

126

B. E. Eckbo, Valuation effects of corporate debt offerings Table 1

Annual

distribution of the number of firms and debt offerings in the total sample increased their debt by more than the threshold in the period, 1964-1981a Number

Year of issue

Industrials

of firmsb Utilities

Number Total

Industrials

of ofI’eringsC Utilities

Total

Average

of firms that

size of issue ($ mill.)”

Industrials

Utilities

Total

1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981

4 6 18 30 15 13 35 21 11 8 32 27 18 14 18 28 40 41

1 6 6 9 7 14 16 18 14 8 15 13 8 11 8 12 18 12

5 12 24 39 22 27 51 39 25 16 47 40 26 25 24 40 58 53

4 11 21 34 16 16 41 32 13 10 39 35 26 19 29 36 53 62

1 5 8 12 9 22 22 21 16 10 16 12 6 10 7 14 18 17

5 16 29 46 25 38 63 53 29 20 55 41 32 29 36 50 71 79

$ 93 91 137 107 111 112 127 152 111 87 198 171 271 184 299 226 191 226

$ 50 67 71 71 78 86 92 88 52 15 18 04 196 132 131 160 113 134

$ 84 80 119 98 99 97 115 127 134 101 174 157 262 166 267 208 171 206

1964-81

379

194

513

497

226

723

180

110

158

“By selection, the minimum size of any sample issue is $50 mill. in 1964, increasing by 5% annually to $114 mill. in 1981. bThe total data base contains 216 different firms: 176 industrials and 40 utilities. ‘In the years the sample firms made these 723 issues, the Wall Street Journal Index reported a total of 1056 issues by the same companies (699 by industrials, 357 by utilities). 210 issues were excluded as a result of step (2) of the selection procedure, another 33 issues fell below the size limit specified in step (l), while step (3) excluded 90 issues.

offerings is $158 mill.; $180 mill. for industrials and $110 mill. for public utilities. As listed in table 2, the 723 debt offerings consists of 648 issues of straight debt (of which 189 are mortgage bonds) and 75 issues of convertible debt.’ The ‘In table 2, and throughout the paper, ‘straight debt’ is an issue referred to in the WaN Street Journal as a non-convertible bond, note or debenture. Of course, if the Wall Street Journal fails to report all the relevant features of a debt issue, some of the issues classified simply as bonds, notes or debentures may in fact be more complex instruments. As discussed below, I double-checked 430 of the 723 offerings through information in the full coverage sections of Moody’s manuals, generally confirming the Wall Srreer Journal classification. Based on information in the Wall Srreef Journal, Moody’s manuals and Investment Dealers’ Digest Corporate Financing Directory, 670 of the 723 debt issues can be classified as public offerings, another 46 are private placements, while for 7 issues no such classification could be made. In this classification a public offering is one which is explicitly denoted as such in the above sources or one which is offered either through an underwriter or through preemptive rights issued to the firm’s shareholders. The 46 private issues were ah denoted as such in the WaN Streef Journal article announcing the issue. This sample of private offerings were examined separately and, as it turned out, none of the conclusions depend on the distinction between a public and private offering.

422

3 5 15 19 10 11 35 22 12 8 38 34 26 19 29 32 49 55

Industrial firms

226

1 5 8 12 9 22 22 21 16 10 16 12 6 10 7 14 18 17

Public utilities

debth

75

1 6 6 15 6 5 6 10 1 2 1 1 0 0 0 4 4 7

Industrial

Convertible debtc

479

2 8 18 25 15 22 34 33 18 8 35 38 22 23 31 30 58 59

0 12 16 37 17 21 33 23 17 16 41 34 22 18 21 32 60 62 483

Underwritten

25

1 3 2 5 0 0 2 0 0 0 0 0 2 0 0 7 0 3

Rights offer

All issues: ORering method

222

1 5 14 20 14 18 18 22 13 9 16 11 6 9 1 12 9 18

‘ Capital expenditures’

147

13 3 4 14 13 4 2 15 6 7 6 12 10 14 17

f

1 .?

‘ General funding’

All issues: Use of funds!

252

1 6 8 12 7 9 23 8 12 7 19 21 9 10 9 17 39 35

‘Refunding’

classified by the nature of the debt, by offering method and by the use of the fundsa

SEC registeredd

of the total sample of 723 bond offerings

Straight

distribution

“The information in this table is based on the Wull Srreef Journal article announcing the issue. ‘This group contains 189 mortgage bonds, of which 173 were issued by utilities. The remaining issues are classified only as ‘bonds’, ‘notes’ or ‘debentures’ by the Wall Street Journal. ‘None of the utilities in the sampled issued convertible debt, dAn issue is classified here as registered with the SEC if the Wa/I Srreer Journal article announces the actual registration or the issuing firm’s intention to register the issue. Of the 483 ‘registered’ issues, 341 were offered by industrial firms. “Capital expenditure’ indicates that the purpose of the issue was to finance the firm’s capital expenditure (investment) program. The category ‘General funding’ is a term used by the WuN Street Journal and indicates that the proceeds of the debt issue have been earmarked for several different areas which may include financing of new investments. In the ‘Refunding’ case, the proceeds of the debt issue are used to replace old debt.

1964-81

1964 1965 1966 1961 1968 1969 1970 1971 1972 1973 C’1974 1975 1976 1971 1978 1979 1980 1981

Year of issue

Annual

Table 2

B. E. Eckbo, Valuation effects of corporaie debt offerings

128

Table 3 Descriptive

statistics

for the total sample of 723 bond offerings, 495 offerings by industrials

Descriptive

measure

(1) Issue size ($ mill.) (2) Issue size/ Market value of common stockb (3) Issue size/ Long-term debt’ (4) Issue size/ Long- and short-term debtC (5) Long- and short-term debt’/ Market value commonb (6) Change in long-term debtd/ Issue size (7) Change in long- and short-term I debtd/Issue size

1964-1981.a 228 offerings

by utilities

Mean

Median

Mean

Median

$180.0

$150.0

$110.0

$100.0

0.13

0.08

0.12

0.10

0.70

0.23

0.09

0.07

0.15

0.09

0.07

0.06

1.55

0.70

1.70

1.67

1.77

1.20

1.50

1.33

2.53

1.70

1.44

1.36

“The information in this table is based on the Annual Compurtat tape, and, for the issue size, on the article in the Wall Street Journal announcing the issue. bStock price is closing price at the end of the month preceding the month of the debt offering. CThe debt level is measured as the sum of two components: the first is the size of the debt as listed on the Compustat tape as of the beginning of the year of the offering. The second component is the sum of all earlier debt issues in the sample made by the issuing company that year. dThe change in the debt is measured as the difference between two components: the first is the size of the debt change as listed on the Compustat tape for the year of the offering. The second component is the sum of all earlier debt issues in the sample made by the issuing company that year.

public utilities in the sample issue almost all (173) of the mortgage bonds, and none of the convertible debt. In 483 of the 723 offerings the Wall Street Journal article mentioned the issuing firm’s intention to register the offer with the SEC. Furthermore, 479 issues were said to be offered through an underwriter, while only 25 issues were identified as being offered through rights given to the issuing firm’s shareholders. Finally, based on the Wall Street Journal information, the proceeds of 222 issues were earmarked for the firm’s capital expenditure (investment) program, while the purpose of another 147 issues was ‘general funding’. 252 issues were used to refund old debt, while for 102 offerings there was insufficient information in the Wall Street Journal to classify the issue as to the intended use of the funds. Table 3 lists several characteristics of the pre- and post-issue financial structure of the sample firms. The information is taken from the Compustat tape, adjusted using the information on new issues in the sample. According to the second row, the average industrial offering represents 13% (median 8%) of the market value of common stock as of the end of the month prior to the month of the issue. The corresponding relative size of the average issue by a utility is 128 (median 10%). Furthermore, the average issue size is 15% of the

B. E. Eckbo, Valuation effects ofcorporate debt offerings

129

sum of the industrial firm’s long- and short-term liabilities prior to the issue, and 7% of the public utility’s long- and short-term debt. The median utility company is more highly levered than the median industrial firm in the sample: the ratio of long- and short-term debt to market value of common stock is 1.67 for the former and 0.70 for the latter. In the period from the offering to the end of the same year, the average industrial firm increased its long-term debt by a factor of 1.77 relative to the size of the offering. For utilities the factor is 1.50. Over the same period, both categories of firms on average also experienced a net increase in the sum of their long- and short-term debt by a factor of 1.4 or higher relative to the offering size. Since the sampling procedure picks up 68% of the total number of debt issues by a sample firm in any given sample year (with an even larger representation on a dollar-value basis), it is therefore reasonable to argue that the majority of the issues in the sample served to increase the total debt level of the issuing firm. Thus, it is also likely that these debt offerings conveyed leverage-increasing new information to the market at the time of the initial Wall Street Journal announcement.8 Information on the original issue discount (the percent difference between the face value and the market value of the debt when sold), the underwriter spread (the percent difference between the market price received by the underwriter and the price received by the firm from the underwriter) and the rating of the bond was collected for 430 issues which were listed in the full-coverage sections in one of the four Moody’s Industrial, Public Utilities, Banking and Finance, and Transportation manuals as of 1982.9 Relative to the face value of the debt, the median offer discount is 2.05% for (262) issues by industrial companies and 0.61% for public utilities, while the mean underwriter spread is 0.61% and 0.86% for the two categories of firms. Moody’s rating of these issues ranges from Aaa to Caa for the industrials and

‘The information in table 3 is comparable to the descriptive measures given in table 2 of Dann and Mikkelson (1984). For example, in their sample of 125 convertible debt offerings. the mean issue size is $55 mill. (median $30 mill.), while the issue size is on average 22% (median 15%) of the firm’s market value of common stock. Thus, while the typical issue size in my sample is approximately three times the average issue size in the Dann and Mikkelson paper, the issue size in percent of market value of common stock is approximately the same in both studies. In other words, the average firm in my sample has a market value of equity which is approximately three times the equity value of the typical Dann and Mikkelson firm. This is probably a reflection of my sampling procedure which requires a firm to be listed on the Compwtat tape. Note also that Dann and Mikkelson report the mean ratio of the change in total liabilities to issue size to be 1.57 (median 0.75), which they interpret as a measure of the extent to which the issue represents new financing versus refinancing of existing debt. This is comparable to row (7) in table 3 above, where the mean and median values are somewhat higher (for industrials the mean is 2.53 with a median of 1.70). ‘These 430 isues are quite evenly distributed over the 18 years in the sample period. Thus, using the 1982 manual as a screen does not introduce a notable bias towards issues in the later years of the sample period. This is a reflection of the fact that most of the debt issues in the data base have maturities of 20 years or longer. Moody’s rating is taken from the manual representing the year subsequent to the year of the offering.

B. E. Eckho, Valuation effects of corporate debt offerings

130

from Aa to Baa for the utilities. 50% of the offerings by either group of firms are rated A or higher, while 50% are rated A or lower. 4. Estimation 4.1. Abnormal

stock returns

For each debt offering in the data base, I recorded the dates of all issue-specific announcements in the Wall Street Journal Index within the year of the offering. lo Following the tradition in the literature, the market reaction to each issue-related announcement is proxied by the abnormal stock returns over the two-day trading period that encompasses the Wall Street Journal publication day (day 0) and the preceding day. This two-day announcement period is motivated by the fact that ‘it cannot be determined from published sources whether the initial post-announcement market transaction preceded or followed the close of trading on the trading day prior to the published announcement in the Wall Street Journal’ [Dann and Mikkelson (1984, p. 162)]. The results reported in Masulis (1980), Dann (1981) Vermaelen (1981) Mikkelson (1981), Dann and Mikkelson (1984) Asquith and Mullins (1986) and Masulis and Korwar (1986) indicate that the market reaction to capital structure changes occur almost entirely within this two-day period. I reach a similar conclusion after repeating the basic procedure of this paper using the larger windows spanning to - 1, + 1 and - 10, + 10 periods. The abnormal return over period - 1,O is estimated using the coefficient y,, in the following market model: N

‘I* =

a~+ Pjrmt +

C Y,ndnt+ E~t)

n=l

where r,, is the continuously compounded return to the continuously compounded return to the value over day t; d,, is a dummy variable which takes on or day - 1 relative to the announcement date of the

(1) security j over day t; r,,,, is weighted market portfolio a value of one if t is day 0 n th event for firm j and a

“There were four types of announcements: (1) the announcement of the company’s plans to issue the new debt (prior to the SEC registration), (2) the announcement of the registration of the issue with the SEC, (3) the offer announcement itself, and (4) the announcement that the issue is ‘sold out’. While all offerings in the sample by selection have at least one announcement each, 206 offerings have at least two announcements, 14 offerings have three announcements, while none have four announcements. The distribution of the initial (first) announcement is as follows: 403 issues have announcement (1) as the first; for another 227 issues the first announcement is of type (2); 15 issues have announcement (3) as the first; while for the remaining 78 issues the first announcement is of type (4). Thus, 631 issues were first announced prior to or in connection with the SEC registration of the issue.

B. E. Eckho, Valuation efects of corporate debt offerings

131

value of zero ctherwise; and E,, is assumed to be a mean zero, normally distributed error term which is independent of both r,,,, and d,,. While the coefficient j3, extracts market-wide movements from the return series, the abnormal return parameter y,, directly isolates the component of the security’s daily return which is due to the event itself. The value of y,, multiplied by 2 represents the two-day abnormal return relative to event n, AR,,,. The estimation period is organized on a calendar year basis, such that the N events associated with the jth regression span all issues in the sample made by the j th firm in a given year. In other words, I perform a simultaneous estimation of the two-day abnormal returns relative to all announcements concerning all the debt offerings of a given firm in a given year. As a result, the existence of multiple events in a given year will not confound the estimation of aj and fi, which form the basis for the estimate of the firm’s ‘normal’ returns.” The two-day average abnormal return relative to event n and across a sample of J bond offerings is defined as

AAR&

If the J events

iAR,,=$y,,. j=1

are independent,

j=l

(2)

it follows that

where a?,,, is the standard deviation of y,,. Under the hypothesis that AAR, = 0, and replacing the true values of y,, and aY,,, with their OLS estimates, this Z-statistic is approximately standard normal for large J. Note that since the dummy variables d,, in eq. (1) are orthogonal, the same statistic applies when aggregating y,, across the N euenfs as well as across J firms. “For each firm the estimation period includes the 150 trading days prior to the day of the first event and the 150 trading days following the day of the last event that year. Thus, abnormal returns are estimated using at least 301 observations, and more if the firm has multiple events in a given year. Note that the estimation period in one year extends backwards and/or forwards to the adjacent years. If, according to the information in the sample, the same firm issued bonds in these adjacent years, I always exclude the two days surrounding each of these issue announcements from the estimation period. Note also that since a firm’s systematic risk (a,) is a positive function of its leverage [Hamada (1972). Galai and Masulis (1976)], letting the estimation period include returns belore the leverage-increasing event possibly leads to underestimation of 3 and, therefore, overestimation of abnormal returns. Of course, this potential bias cannot explam the presence of negative abnormal returns, an issue which is discussed further in section 5.

132

4.2. Abnormal

B. E. Eckbo, Valuation effects of corporate debt offerings

changes in earnings

Let E,, denote the earnings before interest and taxes of company j over year t, and let AE,,= E,,- Ej r_l. When estimating abnormal changes in earnings, the influence of market-wide movements in the time series of earnings changes in extracted using a market model analogous to model (1):

where AE,, is the change in market earnings based on an equal weighted index of all firms on the Compustaf tape having data available in period t.12 The OLS estimate of y,, represents the estimate of the firm’s abnormal change in earnings over year r. I use the 7 years of data immediately preceding the event year (i.e., years -7 through - 1) in the estimation. Furthermore, the dummy variable d, takes on a value of one in the event year, which is either year 0, year + 1, or year + 2. Thus, estimation of abnormal changes in earnings for the years 0, + 1, and + 2 requires re-estimation of eq. (4) three times. When estimating y e,, + 1 year 0 is deleted from the time series of earnings changes. Similarly, the estimation of yei, +2 involves deleting observations 0 and + 1 from the time series. As a result, the OLS estimates of (Y,, and /?,, remain the same across the estimation of the event parameter for each of the three event years, preserving the predictive nature of the estimates of abnormal earnings. The procedure requires at least ten consecutive annual earnings observations (years -7 through +2) are available on the Compustat tape for a firm to be included in the analysis involving abnormal earnings.

4.3. Debt-related

tax shield

Two alternative empirical proxies for the market value of the increase in the issuing firm’s debt-related tax shield are examined. The first is the corporate tax rate (assumed to be 0.48 for all companies) multiplied by the face value of the debt. This is an appropriate proxy if (i) the debt is sold at par, (ii) the debt issue is viewed as a permanent increase in the leverage of the firm, and (iii) the market assigns a zero probability to the event that, in any given year, the firm will not be able to fully utilize the interest expenses to decrease corporate “See, e.g., Ball and Watts (1972). Albrecht, Lookabill and McKeown (1977), Watts and Leftwitch (1977) and Beaver, Clarke and Wright (1979) for evidence on the time series behavior of annual earnings. The latter study reports significant rank correlations between abnormal stock returns and the forecast errors of a model such as eq. (4) (without the dummy variable). To gauge the sensitivity of the results to the specification of the model used to forecast changes in earnings, I also computed abnormal changes in earnings based on the average change in earnings over the seven years up to and including year - 1 relative to the year of issue. Use of this particular method, which is consistent with the evidence that annual earnings follow a Martingale, did not alter any of the conclusions in the paper.

B.E. Eckbo, Valuation effects

ofcorporatedebt

offerings

133

taxes. To accomodate the more general case, the second proxy is computed as the corporate tax rate multiplied by the sum of the present value of a tax deductible original issue discount and the interest payments over the lifetime of the debt issue. The IRS treats an original issue discount of a certain minimum size as an expense which, since 1969, must be allocated over the lifetime of the bond.13 Denoting the face value of the debt as F, the market value of the debt when issued as B, the annual coupon rate as C, the number of years to maturity as M, and the risk-adjusted (constant) discount rate as r, the tax shield is estimated as 0.48 times TS, where

TS=

F-B M+CF

1

l-(l+r)-M r

and where the first term in the summation equals F - B for sample years prior to 1969. I approximate r with C( F/B) (compounded semiannually) which, of course, is strictly correct only if I is constant and if the debt is expected to be permanent. If r is constant, the error implied by using this adjusted coupon rate is smaller the larger the maturity (M) of the debt. Information on the parameters necessary to estimate TS is available only for those debt issues in the data base which are listed in the full-coverage section of Moody’s manual. 5. Empirical results 5.1. Analysis 5.1.1.

Straight

of average abnormal returns debt

Table 4 lists the two-day announcement period average abnormal returns (AAR) to the total sample of 459 straight debt offerings (excluding mortgage bonds) and to the 189 mortgage bonds in the data base. Row (1) of the table gives the AAR relative to the first announcement of the offering in the Wall Street Journal, while rows (2) and (3) list the AAR relative to any subsequent Wall Street Journal announcements pertaining to the same issue. Rows (4)-(7) classify the first offer announcement according to the nature of the Wall Street Journal information. Finally, the two last rows list the AAR when the two-day announcement period returns of all announcements pertaining to (i) one issue and (ii) all issues by one firm in one year, are cumulated into one total abnormal return. The former abnormal return approximates the full stock price effect of a given debt offering, while the latter captures the cumulative 13According to Section 368(a) is smaller than l/4 of 1 percent years to maturity (i.e., 2.5% for Prior to 1969, the discount was

(1) of the Internal Revenue Code, an original issue discount which of the redemption price at maturity, times the number of complete a ten-year bond), is treated as a zero discount for tax purposes. fully tax deductible in the year of the debt issue.

two-day

announcement

Nature ofjirst

of

nnnouncemeni

of

376 (-

-0.13 1.05; 44.7)

-0.11 (-0.96; 45.5)

148

189

17

- 0.22b (- 1.67; 38.8)

49 459

2

66

104

4

-0.81 (- 1.37; 45.5)

-0.16 ( - 1.08; 48.0)

-0.10 (-0.35; 48.5)

- 1.48’ (- 2.01; 20.0)

59

189

11

127

272

5

-0.15 (-0.75; 43.5)

- 0.06 (- 0.44; 47.2) 1.67; 47.1)

- 0.20b

73

75

12

2

34

27

5

32

75

N

AAR

debt

- 1.75d (- 5.13; 26.0)

- 1.70d (- 5.06; 25.3)

- 1.38b (- 1.87; 25.0)

-1.45 (- 0.91; 0.0)

- 1.42d (- 3.74; 17.6)

- o.97c (- 1.97; 33.3)

0.44 (0.79; 60.0)

- 1.13d ( - 2.68; 43.8)

( - 4.60; 24.0)

- 1.25d

(Z; % positive)

Convertible

and by

of issues in the average. while ‘% positive’ is the

- 0.23b (- 1.80; 44.6)

-0.18b (- 1.68; 44.4)

- 0.01 (0.28; 47.1)

- 2.02 (- 1.42; 0.0)

- 0.20 (- 0.90; 47.0)

-0.18 ( - 0.21; 47.5)

1.05 (1.11; 100.0)

- 0.01 (- 0.56; 40.7)

(-

AAR

bonds

(Z; % positive)

N

Mortgage

AAR

bonds

(Z; % positive)

debt except mortgage

Z-statistic tests the hypothesis that AAR = 0 [see eqs. (2) and (3) in the text]. N is the number of the issues with positive abnormal returns. hypothesis that AAR = 0 is rejected on a 10% level of significance. hypothesis that AAR = 0 is rejected on a 5% level of significance. hypothesis that AAR = 0 is rejected on a 1% level of significance.

Sum ofUN announcements of u given $rm in n grven yew

Sum of nil announcements of 0 given issue

“The percent bThe CThe dThe

D:

C:

(7) Announcement that the offer is ‘sold out’

(6) Announcement the offer

(5) Announcement of SEC registration

plans to issue

(4) Announcement

B:

(3) Third announcement of issue

of issue

115

N

Straight

(2) Second

order

Table 4

period average abnormal stock returns (AA R) to firms issuing debt, classified by the type of the debt instrument the nature of the WuN Street Journal announcement; total sample, 1964-1981.a

459

Chronological

announcement

(1) First announcement of issue

A:

Announcement period

Percent

B. E. Eckho, Valuarion effects of corporate debt oflerings

135

effect of possibly a series of offerings over one year. Although reported in table 4, the one-year cumulative abnormal return is of interest primarily in the context of the subsequent analysis of post-offer abnormal changes in annual earnings (table 9). As is apparent from table 4, news of a straight debt offering is on average associated with zero or negative announcement period abnormal returns. The 459 straight debt offerings (the total sample net of mortgage bonds) are associated with average abnormal returns of - 0.06% (Z-value of -0.44) relative to the first announcement of the issue. The corresponding abnormal performance by firms offering mortgage bonds is -0.208, with a marginally significant Z-value of - 1.67. The AAR generally appears with a negative sign across the various subdivisions of the two samples; however, only mortgage bonds seem to be associated with abnormal stock returns which are (marginally) different from zero. According to the last two rows of table 4, when aggregated over all announcements of a given issue as well as across all issues within a given year, firms offering mortgage bonds earn average abnormal returns of -0.18% (Z-value of - 1.68) and -0.23% (Z-value of - 1.80) respectively. The corresponding abnormal performance by firms issuing straight and -0.13 (Z= debt other than mortgage bonds is -0.11% (Z= -0.96) - 1.05) i.e., essentially zero. The results for the sample of 189 mortgage bonds compare closely to the two-day announcement period average abnormal returns of -0.33% (t-value of - 1.76) reported by Dann and Mikkelson (1984) for their sample of 150 straight debt issues. Since Dann and Mikkelson do not provide information on the particular nature of their straight debt issues, it is not clear to what extent the negative abnormal performance in their sample is driven primarily by mortgage bonds. In any event, the results in table 4 for the 459 straight debt offerings indicate that the issuance of straight debt most likely will have neither a positive nor a negative impact on the issuing firm’s stock price. Table 5 and 6 contain additional information on the stock price reaction to straight debt offerings (now including the mortgage bonds). In both tables the samples are classified using information in the Wall Street Journal article announcing each offering. The data base is partitioned according to the offering method (underwritten versus rights offer), the purpose of the debt issue (refunding old debt, financing new investments, and general funding) and by Moody’s rating of the bonds. Table 5 focuses on debt offerings made by industrial firms, while table 6 examines debt issues by public utilities. The 422 industrial debt offerings in table 5 are generally associated with zero average abnormal returns regardless of the way the sample is partitioned. This is in contrast with the results for the 226 straight debt offerings by public utilities listed in table 6. When the Wall Street Journal article contains information on the (eventual) SEC registration of the debt issue, the announcement period average abnormal return is essentially zero, as was the case for

B. E. Eckbo, Valuation effects of corporate debt offerings

136

Table 5 Percent two-day announcement period abnormal returns (AAR) summed over all announcements of a given debt issue and averaged across issues, classified by the offering method, by the use of the funds and by Moody’s rating; sample of offerings by industrial firms, 1964-1981.” Straight

Sample A

N (SEC registered)

classification

: By oflering

offerings

310 (236)

(2) Rights offerings

11 (5)

old debt

(4) Finance capital expenditures (5) General

funding

By Moody’s

(6) Rated

- 0.12% (-1.01;45.8) 0.36 (0.53; 30.0)

154 (120)

-0.10 (- 0.68; 44.2)

(;:)

- 0.20 (- 0.66; 45.2)

100 (78)

- 0.03 (- 0.04; 48.01)

AAR (Z; % positive)

(ii) 14 (8)

- 1.90%d ( - 4.70; 24.5) - 0.77 (- 1.07; 41.7)

121 (94)

0.02 (- 0.29; 47.9)

(ii)

-0.36 (- 1.26; 42.7)

(8) Rated

(ii)

0.47 (0.89; 61.5)

Aaa-Aa

Baa - Caab

All issues

(E) (Z) (E)

- 1.86d (- 2.87; 34.9) - 2.22d (- 3.52; 27.9) - 1.27’ (-2.18;21.1)

rating

(7) Rated A

D:

N (SEC registered)

debt

By use of funal

(3) Refund

C:

AAR (Z; % positive)

Convertible

merhod

(1) Underwritten

B:

debt

422 (292)

- 0.05 (- 0.50; 46.9)

8

3,

-0.44 (- 0.61; 44.4) - 0.75 (- 1.36; 42.8)

(i)

- 2.42d (- 3.90; 16.6)

(::)

- 1.71d (- 5.06; 25.3)

=The Z-statistic tests the hypothesis that AAR = 0 [see eqs. (2) and (3) in the text]. ‘B positive’ is the percent of the issues with positive abnormal returns, N is the number of issues, while ‘SEC registered’ is the number of the N issues where the WaN Street Journnl article announcing the offering also made reference to the SEC registration of the issue. The rating information is from Moody’s manual for the year subsequent to the year of the offering and was collected for issues which remained listed in the full coverage section of the 1982 manual. An issue is included in this table only if there is sufficient information in the Wall Sfreef Journal article to perform the classification. Separate analysis of the ‘SEC registered’ issues yields results which are indistinguishable from the results in this table. bOf the 26 straight debt issues twenty-one are rated Baa, one Ba, two B and two Caa. Of the 24 convertible debt issues nine are rated Baa, eight Ba and seven B. ‘The hypothesis that AAR = 0 is rejected on a 5% level of significance. dThe hypothesis that AAR = 0 is rejected on a 1% level of significance.

B. E. Eckbo,

Valuation

efects of corporate

debt offerrngs

137

Table 6 Percent two-day announcement period abnormal returns ( AAR) summed over all announcements of a given debt issue and averaged across issues, classified by the offering method, by the use of the funds and by Moody’s rating; sample of straight debt offerings by public utilities, 1964-1981.a Offerings with no WSJ information on SEC registration

Offerings with WSJ information on SEC registration

AAR ( Z: % positive)

AAR

Sample A:

classitication

Bv offerrng

N

method

(1)

Underwritten

(2)

Rights offerings

B:

( Z; % positive)

N

offerings

71 0

-0.01% ( - 0.34; 42.2) -

44

- 0.78gd (- 2.62; 36.3)

2

-0.39 ( - 0.21; 50.0)

Bv we of funds

48

~ 0.20 (-0.55; 43.8)

29

PO.17 (-0.26; 55.1)

(4) Finance capital expenditures

66

- 0.22 (- 1.13; 37.9)

34

- 0.81d (- 2.62; 35.3)

(5) General

23

0.39 (0.70; 47.8)

5

~ 0.98 (~ 1.16; 20.0)

(6) Rated Aaa-Aa

21

- 0.21 ( - 0.82; 40.0)

10

- 1.34c (~ 1.94; 29.9)

(7) Rated A

61

-0.26 (- 1.09; 38.0)

34

- 0.65’ ((2.18;41.2)

(8) Rated

28

0.03 (0.04; 39.2)

12

0.06 (0.52; 50.0)

140

-0.13 ( - 0.96; 41.4)

86b

~ o.50c (- 2.20; 43.4)

(3) Refund

c:

D:

old debt

funding

LQ Moody’s

Baa

AN issues

ratrng

“The Z-statistic tests the hypothesis that AAR = 0 [see eqs. (2) and (3) in the text]. ‘% positive’ is the percent of the issues with positive abnormal returns, while N is the number of issues. The classification is based on information in the Wall Streer Journal (WSJ) article announcing the issue, and for the ratings on Moody’s public utility manual as of the year subsequent to the year of the issue. Moody’s rating was collected for those issues which remained listed in the full coverage sections of the 1982 manual. bOf these 86 issues, eight are private placements with AAR of - 0.03 (Z-value of 0.21). ‘The hypothesis that AAR = 0 is rejected on a 5% level of significance. dThe hypothesis that AAR = 0 is rejected on a 1% level of significance.

B. E. Eckho, Vrrluation effects

138

of corporate debt offerings

offerings by industrial firms. However, when the Wall Street Journal article does not contain information on the SEC registration, the effect is significantly negative: the 86 issues in this category earn average abnormal returns of - 0.50%, with a Z-value of - 2.20.14 The largest negative effect occurs for the sample of 34 offerings where the new debt is intended (according to the Wall Street Journal) to finance the utility’s investment program. The average abnormal return for this particular sample is -0.81%, with a Z-value of -2.62. Notice also that there is a negative relation between the sign of the AAR and the rating of the bond issue: Utilities issuing bonds rated Aaa-Aa earn average abnormal returns of - 1.34% (Z-value of - 1.94) while the bonds in this category which are rated Baa are associated with statistically insignificant average abnormal returns of 0.06% (Z-value of 0.52). However, the difference between the two average abnormal returns is not statistically significant on a 10 percent level. Note that the relative ranking of the average abnormal returns across each subsample in table 6 (ignoring, for the moment, the issue of statistical significance) is the same regardless of whether or not the Wall Street Journal article contains information on the eventual SEC registration of the issue. This is consistent with the proposition that first announcements where the Wall Street Journal does not mention anything about the SEC registration, typically occur relatively earfy in the process which eventually leads the market to fully anticipate the debt issue, thus representing more of a surprise event. However, while this may in part explain the greater significance levels in the sample with no information on the SEC registration, it almost certainly does not capture the entire explanation, since no comparable difference is detected for debt offerings made by industrial firms. Of the 422 straight debt issues in table 5, 130 offerings were without Wall Street Journal information on the eventual SEC registration. Although not shown in the table, the results for these 130 cases are indistinguishable from the results for the remaining 292 cases.

5.1.2.

Convertible

debt

Table 4 offers strong evidence that the issuance of convertible debt conveys negative information to the market: The average two-day abnormal return relative to the initial announcement of the 75 issues is - 1.25% (Z-value of -4.60), while the second announcement causes a further negative abnormal

14F_ight of the 86 issues are private placements with a corresponding average abnormal performance of - 0.03 (Z-value of 0.21). Thus, the significantly negative abnormal performance concerns primarily the 78 public offerings on this particular subsample.

B. E. Eckho, Vuluurion effecrs of corporute debt oflerrngs

139

performance of - 1.13% (Z-value of - 2.68). l5 In 27 of the 75 issues the first announcement concerns ‘plans to issue’, while another 34 issues are first announced in connection with the SEC registration. The former type of announcement causes a negative market reaction which translates into average abnormal returns of - 0.97% (Z-value of - 1.97). The latter announcement is associated with negative average abnormal returns of - 1.42% which are more than three standard deviations from zero. The two-day abnormal return cumulated over all Wall Street Journal announcements pertaining to a given issue is on average - 1.70%, with a Z-value of - 5.06. A further aggregation over all convertible debt issues by a given firm in a given year yields AAR of - 1.75% and a Z-value of - 5.13. Furthermore, it appears from table 5 that convertible debt offerings through preemptive rights on average cause a somewhat smaller valuation effect than do underwritten offerings. The average abnormal returns to industrial firms issuing convertible debt through an underwriter is - 1.90%, with a Z-value of -4.70. In contrast, convertible debt rights offers are on average associated with abnormal returns of - 0.77% (Z = - 1.01). However, the f-value testing the hypothesis that the valuation effects of the two offering methods are different is only 1.06. Thus, although the small sample size makes it somewhat difficult to draw any strong conclusions, the proposition that the two valuation effects are equal is not rejected. Consequently, the proposition that the negative announcement effect of convertible debt offerings is due primarily to a transfer of an original issue discount to new bondholders is not supported by the data. These results are generally consistent with results reported by Dann and Mikkelson (1984). Based on 132 convertible debt issues (which they argue increased the financial leverage of the issuing firms), they estimate the two-day average abnormal return, relative to the first Wall Street Journal announcement of the issues, to be -2.31%, with a t-value of -7.70. A further capital loss is incurred around the issuance date, with two-day average abnormal returns of - 1.54% (t-value of -4.81). On the basis of the relative valuation effects of rights and underwritten offerings they also fail to support the proposition that the negative announcement effect of underwritten convertible debt offerings primarily reflects the value of an original issue discount transferred to new securityholders. 15The results in table 4 relative to the second Wall Strew Journal announcement of the issue does not, of course, necessarily mean that one can make profits from a trading rule based on selling short the shares of firms that announce a convertible debt offering and subsequently close the short position after any second announcement of the issue. Suppose that the terms of the debt issue are not completely determined at the time of the first announcement, and that only those issues where the terms are subsequently being made less favorable to the issuing firm receive a second announcement in the Wall Sfreef Journul. If the ‘good news’ (i.e., no revision of the terms of the issue) are not announced in the WuN Street Journul, then the significantly negative secondannouncement returns in table 4 reflect a sample selection bias.

B. E. Eckbo, Valuation effects of corporate debt offerings

140

Given the evidence of a significantly negative market reaction to new equity issues [Asquith and Mullins (1986), Masulis and Korwar (1986)], the strong negative valuation effect of a convertible offering is likely to reflect the equity feature of convertible debt. However, the possibility remains that the AAR methodology fails to uncover important cross-sectional evidence which can explain the above results also in terms of the characteristics of the sample of straight debt. The remainder of this section explores this distinct possibility. 5.2.

Analysis

of cross-sectional

regression results

Tables 7 through 10 list OLS estimates of the coefficients in cross-sectional regressions which relate the two-day announcement period abnormal return to firm- and issue-specific characteristics. The regressions are organized according to the predictions of the zero, positive, and negative impact hypotheses discussed in section 2. With the exception of table 9, each regression specification is estimated using two alternative dependent variables. The first is the two-day abnormal return relative to the first announcement of the debt offering in the Wall Street Journal, AR,. The second is the sum of the two-day abnormal returns relative to all Wall Street Journal announcements of the debt offering, C,AR,. In table 9 the dependent variable is c,(c,AR;), where the index j runs across all debt offerings made by the company over a given sample year.16

5.2.1.

The underwriter

spread and the stated purpose of the issue

In table 7, I examine whether the abnormal return is related to the underwriter spread (COST) as well as the rationale behind the offering, including refunding and financing of capital expenditures. COST is the market value of the offering received by the underwriter minus the payment from the underwriter to the firm, in percent of the market value of the common stock as of the month prior to the month of the offering. The motivation for these regressions is the zero impact hypothesis, which holds that any valuation effect of a debt issue reflects factors other than the capital structure change per se. Since this hypothesis does not discriminate between alternative debt instruments, both straight and convertible debt are included in the regressions. The coefficients multiplying the capital expenditure and refunding variables in ‘“Statistical inferences based on the OLS estimates of the parameters in the cross-sectional regressions are valid only under the assumptions of homoscedasticity and cross-sectionally uncorrelated error terms. The assumption of zero contemporaneous correlation of the error terms is justified as the debt offerings in the data base take place at different points in calendar time. To gauge the importance of a possible violation of the assumption of homoscedasticity I repeated all regressions using weighted least squares (WLS). The estimated standard error of the two-day abnormal return was used to transform the data. The results based on the WLS procedure were indistinguishable from the OLS results and are therefore not reported

B. E. Eckbo, Valuation effects of corporate debt offerings

141

Table 1 OLS estimates of coefficients in cross-sectional regressions of the two-day announcement period abnormal stock return (AR) on the relative cost (COST) of the debt offering, with index variables based on the intended use of the proceeds from the offering, 1964-1981 (r-values in parentheses). Dependent variable” I:

Independent CONSTANT

COST

variablesb I(CAP.

EXP)

I( REFUND)

R2

Fstatistic

618 debt offerings with information on the use of the funds

(1)

AR,

- 0.078 (- 0.47)

- 0.324 (- 1.52)

-0.134 ( - 0.65)

0.004

1.23

(2)

C,AR,

- 0.158 ( - 0.84)

- 0.376 (-1.55)

-0.119 ( - 0.50)

0.004

1.36

II:

390 debt oferings from sample I with Moody’s data on COST

(3)

AR,

0.057 (0.26)

- 1.586 (-2.15)

- 0.366 (- 1.41)

- 0.030 ( - 0.11)

0.018

2.33

(4)

C,AR,

0.013 (0.05)

- 1.594 (-1.94)

- 0.479 (-1.66)

-0.15 ( - 0.51)

0.016

2.14

aAR, is the percent abnormal stock return over day - 1 and day 0, relative to the first announcement of the debt offering in the Wall Sweet Journal. EAR, is the sum of the two-day announcement period returns across all announcements of the offering in the Wall Street Journal. [See eqs. (1) and (2) in the text for estimation.] bCOST is the market value of the offering received by the underwriter minis the payment from the underwriter to the firm (i.e., the underwriter spread) divided by the market value of common stock as of the month prior to the month of the offering, times one hundred. The index variable I( A’) takes on a value of 1 if the debt issue has characteristic A’, and zero otherwise. CAP. EXP indicates that the funds will be used to finance the firm’s capital expenditure (investment) program, while REFUND indicates that the funds will be used to refund existing debt (based on information in the Wall Sweet Journal).

regressions (1) and (2) are all insignificantly different from zero. Thus, the results do not indicate that the valuation impact of the 618 debt offerings depends on these two motives for the external financing. Furthermore, in regressions (3) and (4), the COST variable appears with a significant coefficient. For example, regression (3) implies that a one-percent increase in the underwriter spread implies negative abnormal returns of - 1.58%. With a r-value of - 2.15, this particular coefficient is different from zero at a 5% level of significance. Note that although the underwriter spread represents only part of the total costs of a debt offering [Smith (1977)], it is clear from the parameter value of - 1.58% that the COST variable picks up more than just the transaction costs of the issue. Given that the average debt issue in the sample is 13% of the market value of common stock, an abnormal stock return of - 1.58% on average translates into 12% (1.58/0.13) of the size of the debt offering, or approximately 20 million dollars. In regression (4) the index variable representing debt issues intended to finance new investments produces a marginally significant and negatiue coeffi-

142

B. E. Eckbo, Valuation effects of corporate debt oferings

cient. This is consistent with the evidence presented earlier in tables 5 and 6, where there was a tendency for debt offerings to produce a larger negative valuation effect when the debt was intended to finance the issuing firm’s capital expenditure program rather than refund old debt. Under the zero impact hypothesis, which relies on informational symmetry between the firm and outside investors, one would expect the opposite to happen: If anything, debt issued to finance new investment opportunities should lead to the market to capitalize the (presumably) non-negative values of the new investment projects. A possible explanation is that the news of the investment projects reaches the market prior to the news of the financing decision. For example, McConnell and Muscarella (1985) find a significantly positive average valuation effect when firms announce increases in their capital expenditure programs. I do not know to what extent the debt offerings in this paper are systematically preceded by such capital expenditure announcements. However, if such announcements are prevalent it is likely that the evidence presented here reflects a resolution of uncertainty concerning the method of financing only, and not changes in expectations concerning the issuing firms’ investment programs. 5.2.2. Debt-related tax shield and abnormal changes in earnings Tables 8 and 9 address the positive impact hypothesis which predicts that a leverage-increasing capital structure change will result in a positive revaluation of the firm’s shares. The regressions include straight debt offerings for which there is sufficient Wall Street Journal information to classify the issue as to the intended use of the funds. Straight debt offerings where the purpose is to refund old debt (which therefore do not necessarily increase the firm’s leverage) are excluded from the analysis. Although this hypothesis does not distinguish straight from convertible debt per se, I single out the effect of convertible offerings using the index variable Z(CONV) in table 8 and by separate regressions in table 9. In both tables TAX1 is the face value of the debt multiplied by an assumed corporate tax rate of 0.48, while TAX2 is 0.48 times the sum of the present values of the original issue discount and interest expense over the lifetime of the bond. In table 9, the variable A EARN( t) is the abnormal change in the issuing firm’s earnings before interest and taxes in year t relative to the year of the issue, divided by the market value of common stock. There is no evidence in table 8 of a significant relation between the dependent variable and COST, TAXI, or TAX2. On the other hand, in regression (1) the tax shield variable for convertible debt [TAXI *Z(CONV)] appears with a statistically significant coefficient of - 0.13 (t-value of - 3.84). In regression (2) the same coefficient is -0.16, with a t-value of -4.21. The question remains, however, whether this negative correlation is driven primarily by the tax shield variable (TAX1 ) or by the index variable (I), where the latter picks up the level of the average abnormal returns from convertible debt

8. E. Eckbo, Valuation eflects of corporate debt offerings

143

Table 8 OLS estimates of coefficients in cross-sectional regressions of the two-day announcement period abnormal stock return (AR) on the relative cost (C0.V) and tax shield (TAX) of the issue, with index variable for convertible debt offerings (CONV), 1964-1981 (r-values in parentheses). Dependent variable= I:

Independent CONSTANT

COST

TA XI

variablesb TAXI *I(CONV)

TAX2

R*

Fstatistic

366 debt offerrngs with informorion on the use of the funds, except offerings for the purpose of refundmg old dehtC

(1)

AR,

- 0.125 (- 0.91)

- 0.006 (-0.35)

-0.131 (-3.84)

0.046

8.75

(2)

C/R,

- 0.223 (~ 1.43)

- 0.004 (-0.19)

- 0.162 ( - 4.21)

0.053

10.18

II:

245 debt offerings from sample I with doto on COST and TAX2 (based on Moody’s)

(3)

AR,

-0.122 ( - 0.63)

- 0.752 (-0.62)

- 0.014 (-0.55)

0.012

1.47

(4)

C,AR,

- 0.270 (- 1.22)

- 1.028 ( - 0.74)

- 0.007 ( - 0.24)

0.010

1.09

‘AR, is the percent abnormal stock return over day - 1 and day 0, relative to the first announcement of the debt offering in the Wall Street Journal. x,AR, is the sum of the two-day announcement period returns across all announcements of the offering in the Wall Street Journal. [See eqs. (1) and (2) in the text for estimation.] bCOST is the underwriter spread. The index variable I takes on a value of one when the debt is convertible and zero otherwise. All variables arc expressed as a percentage of the market value of common stock as of the month prior to the month of the issue. TAXI is the face value of debt multiplied by 0.48. TAX2 is the sum of the present values of the original issue discount and the interest payments until maturity [see eq. (5) in the text], times 0.48. ‘Inclusion of the 252 additional refunding issues in the data base through a dummy variable multiplying either TAXI or TAX2 leaves the parameter estimates reported in this table unchanged. Furthermore, the coefficient multiplying the additional dummy variable is itself insignificantly different from zero. [In the case of TAXI the coefficient is -0.001 (r-value of -0.08) in the expansion of regression (1). Expanding regression (3) the coefficient is 0.033 with a r-value of 0.87.1

offerings over and above the effect of straight debt offerings. Regression (2) in table 9, which excludes straight debt issues, indicates the answer. The TAXI variable now has a statistically insignificant coefficient while the regression constant is a significant - 2.52 (r-value of - 3.51). A similar conclusion emerges from regression (4) in table 9, where the tax shield is estimated using TAXZ.Thus, I find no statistically significant correlation between the announcement period abnormal return and the change in the firms debt-related tax shield, whether the focus is on straight or convertible debt. As stated in footnote c of table 8, separate regressions were also run using the total sample of 618 bond issues including the 252 refunding issues in the data base. The refunding issues represent a ‘control’ sample since these issues do not significantly alter the issuing firms’ tax shields. The effect of the refunding issues were singled out using a dummy variable multiplying the estimated tax shield. This inclusion of the refunding issues did not alter

TA Xl

0.003 (1.35)

and TA X2

- 2.522 (-3.51)

All firms in sample I wrth rnformation on COST

TA X2 AEARN(0)

- 2.181 (-1.89)

(4) 31 firms issuing convertible debt - 0.867 ( - 0.93)

0.023 (0.89)

- 0.147 (- 1.65)

~ 0.001 (- 0.85)

0.035 (1.10)

- 0.070 (-1.05)

-0.013 (- 0.67)

0.097 (0.94)

- 0.038 (-1.96)

0.083 (1.06)

- 0.013 ( - 0.73)

AEARN

0.065 (0.85)

0.009 (0.59)

- 0.014 (-0.21)

0.025 (1.85)

AEARN(i2)

0.227

0.050

0.047

0.015

R2

1.47

1.90

0.83

1.02

Fstatistic

a Let AR, denote the two-day abnormal return relative to the I th announcement of the j th issue of a given firm within a given year. The dependent variable in t h.IS table is z,F, A R,, COST = underwriter spread; TA Xl = face value of the debt issue multiplied by 0.48; TA X2 = present value of the sum of the original issue drscount and all interest payments on the debt until maturity times 0.48; A EARN( t) = abnormal change in the issuing firm’s annual earnings before interest and taxes in year t relative to the year of the issue(s). All variables are in percent of the market value of common stock as of the month prior to the month of the issue(s).

- 0.510 (- 1.58)

(3) 188 firms issuing straight debt, no refunding cases

issuing convertible debt

-0.124 ( - 0.82)

-0.000 ( - 0.72)

issuing straight debt, no refunding cases

(2) 12 firms

II:

COST

variables”

and issues with information on earnings and the me of the proceeds from the issue

CONSTANT

- 0.044 (-0.15)

Allfirms

(1) 215 firms

I:

Sample

Independent

OLS estimates of coefficients in cross-sectional regressions of the two-day announcement period abnormal return (AR), summed over all announcements of a given debt offering and over all offerings by a given firm within a given sample year, on the relative cost (COST) and tax shield (TAX) of the debt issue, and the issuing firm’s abnormal change in earnings (A EARN) over the year of the issue and the two subsequent years, 1964-1981 (r-values in parentheses).

Table 9

B. E. Eckbo, Valuation effects of corporate debt offerings

145

the coefficients reported in table 8, and the coefficient multiplying the refunding dummy was insignificantly different from zero. This result further corroborates the conclusion that there is no evidence of a relation betwen the announcement-induced abnormal returns and the estimated tax shield of the new debt. This conclusion contrasts with the evidence reported by Masulis (1983) and Mikkelson (1985). Masulis examines valuation effects of the announcement of 126 exchange offers, of which 56 involve issuing debt in exchange for common stock. Mikkelson examines a sample of 164 convertible debt calls. Both studies use proxies for the change in the firm’s debt-related tax shield which are similar to my TAXI and TAX2 variables. Furthermore, both authors find the crosssectional correlation between the two-day announcement period return and the tax shield variable to be consistent with tax-based models of optimal capital structure. Apart from the fact that I focus on a somewhat different capital structure change than do Masulis (1983) and Mikkelson (1985) it is not clear why I reach a different conclusion with respect to the tax issue. One potential explanation is that the tax variable in the Masulis and Mikkelson studies is proxying for a more fundamental information effect which, perhaps, is not present in my sample. That is, a capital structure change may convey information which causes the market to change its assessment of the firm’s future earnings prospects. Under the positive impact hypothesis, this change in earnings expectations is in the direction of the capital structure change. The possibility that the tax shield variable proxies for this information effect is pointed out by both Masulis and Mikkelson, however, neither study attempts to test this information hypothesis. Table 9 lists results of regressions which include both the tax shield variable and estimates of the post-issue abnormal change in the issuing firm’s earnings. Since the abnormal stock return captures the present value of an infinite stream of future abnormal changes in earnings, restricting attention to abnormal changes in earnings in the years 0, + 1 and + 2 is subject to obvious criticism. The approach has some merit if new debt issues, which represent management’s response to expectations of higher earnings, tend to occur in periods close to the periods when the higher earnings actually materialize. This is a reasonable assumption in, e.g., a DeAngelo and Masulis (1980) framework, where the firm is better off postponing the issuance of new debt until the higher earnings can actually support the higher leverage constraint. The results in table 9 do not indicate that the debt issues in the sample were followed by immediate abnormal increases in earnings. In fact, with the possible exception of AEARN( + 2) in the first regression, there is some evidence that the correlation between the abnormal return and abnormal changes in earnings is slightly negatiue. No strong statistical inferences can be made, however, as the hypothesis that the coefficients in the regression are

146

B. E. Eckho, Valuation effects of corporate debt oflerrngs

jointly equal to zero cannot be rejected. ” Since the tax variables in table 9 also appear with insignificant coefficients, the absence of a significant correlation between the abnormal returns and subsequent abnormal changes in earnings leaves open the possibility that tax shield variables will proxy for earningsrelated information effects whenever such effects are present in the data. 5.2.3.

Issue size and bond rating

Table 10 lists regression results pertaining to the negative impact hypothesis. With reference to the Miller and Rock (1985) model, the amount of new financing (SIZE) is included as an explanatory variable. Note that SIZE is used as a proxy for the unanticipated amount of new financing, which is the relevant variable in the Miller and Rock model. With reference to the Myers and Majluf (1984) model I also include index variables for ‘high’ and ‘low’ ratings, where a high rating is in the range Aaa-Aa and a low rating is in the range Baa-Caa. As an alternative proxy for the risk of the bonds, I use the debt-equity ratio (DRA TIO), measured as the sum of the issuing firm’s longand short-term debt divided by the market value of common stock. Given the earlier evidence of significantly negative average abnormal returns associated with convertible debt issues, the effect of convertible debt offerings is also singled out. The regressions fail to reveal a significant correlation between the abnormal return associated with straight debt offerings and either the SIZE, DRATIO and bond rating variables. Although the SIZE variable in regressions (1) and (2) appears to have the sign predicted by Miller and Rock, both the t- and F-tests reject the hypothesis that the coefficient(s) are different from zero. Similarly, the coefficients multiplying the ‘low rating’ variable in regressions (5) and (6) have the sign predicted by Myers and Majluf, however, the standard errors are too large to reject the hypothesis that they are equal to zero. Regressions (3) and (4) confirm the earlier finding of a significant difference between the announcement effect of convertible and straight debt. Given the correlation between the SIZE and TAX1 variables, one can also infer from the earlier results that the two significant SZZE coefficients in table 10 are driven primarily by the difference between the valuation effect of straight and convertible debt offerings, as opposed to by a correlation with issue size per se. The evidence in table 10 is comparable to results presented by Asquith and Mullins (1986) on equity issues. Asquith and Mullins find a significantly

“As mentioned in note 12, computing abnormal changes in earnings using a simple Martingale model does not change the conclusions in table 9. Note also that since the dependent variable in this table is the sum of the valuation effects of all issues of a given firm in a given year, the assumption of contemporaneously uncorrelated error terms in the cross-sectional regressions may to some extent be violated. If so, the r-values in table 9 are somewhat overstated, reinforcing the conclusion of no statistically significant relation between the dependent and independent variables.

B. E. Eckho,

Valuation

effects of corporate

147

deht offerings

Table 10 OLS estimates of coefficients in cross-sectional regressions of the two-day announcement period abnormal stock return (AR) on the relative size of the issue (SIZE) and the pre-issue leverage ratio of the firm ( D/L4no), with index variables for convertible debt and for high and low rating of the debt issue, 1964-1981 (f-values in parentheses). Dependent variable I:

Independent CONSTANT

668 deht offerings

SIZE

DRA TIO

with rnformcrtion on SIZE

variables SIZE*I(

X)

SIZE*I(

RHIGH)

R’

Fstatistic

and DRA TIO

(1)

AR,

PO.183 (~ 1.98)

~ 0.007 (~ 1.08)

0.000 (0.43)

0.002

0.71

(2)

x,AR,

- 0.287 ( - 2.75)

- 0.006

0.000 (0.71)

0.001

0.36

( - 0.83)

II:

723 deht offerings

(3)

AR,

-0.118 ( - 1.31)

(4)

C,AR,

-0.213 (-2.11)

III:

(total duta huse), X = ‘conuertihle

4.23 deht oferings

(5)

AR,

(6)

&AR,

- 0.061 ( - 4.54)

0.030

10.77

0.002 (0.43)

- 0.073 (-4.87)

0.033

11.92

wtth mjormation

-0.126 ( - 0.87)

deht’

- 0.001 ( - 0.23)

on Moody’s rating.

X = ‘ruted low’

- 0.006 ( - 0.42)

- 0.020 (- 1.09)

0.008 (0.49)

0.008

1.07

~ 0.255

- 0.005

0.007 (0.43)

0.85

( ~ 0.30)

- 0.020 ( ~ 1.01)

0.006

( ~ 1.60)

“AR, is the percent abnormal stock return over day - 1 and day 0, relative to the first announcement of the debt offering in the WuN Street Journal. EAR, is the sum of the two-day announcement period returns across all announcements of the offering in the Wn// Street Journal. [See eqs. (1) and (2) in the text for estimation.] hSIZE = face value of the debt issue relative to the market value of common stock as of the month prior to the month of the issue. RHIGH = rated ‘high’ by Moody’s, i.e., a rating of Aaa-Aa. A ‘low’ rating is between Baa and Caa. DRA TIO is the sum of the issuing firm’s longand short-term debt divided by the market value of common stock prior to the debt offering.

negative correlation between the two-day announcement period abnormal returns and a variable such as SIZE. The results presented here suggest that this size-related correlation at best is unique to equity issues.” Furthermore, unless the bonds in my sample are essentially risk-free (in spite of the rating of a substantial portion of Baa or lower), the results in table 10 also indicate that the riskiness of the debt is not a determinant of the market reaction to the offering. This conclusion is also consistent with the evidence in panel C of “Several recent studies conflict with Asquith and Mullin’s (1986) finding of a negative size effect for industrial firms: Bhagat and Hess (1985), Masulis and Korwar (1986) and Bhagat, Marr and Thompson (1985) all conclude that the valuation effect of common stock issues by industrial firms is unrelated to the amount of the issue. Masulis and Korwar (1986) report that the size effect is positive for utilities, Consistent with the results of this paper, Mikkelson and Partch (1986) report that the amount of new financing is unrelated to the valuation effect of bond offerings.

148

B. E. Eckbo, Valuation efects of corporate debt offerings

tables 5 and 6; in both tables a I-test rejects the proposition that the average abnormal returns to firms issuing bonds rated Aa or higher is different from the average abnormal return associated with bonds rated Baa or lower. Although the models by Miller and Rock (1985) and Myers and Majluf (1984) predict the negative market reaction to new issues generally observed for stocks and convertible debt, these models do not fully explain the apparent absence of a size and risk factor in determining the magnitude of the valuation effect of bond issues.”

6. Conclusions This paper examines the effect of more than seven hundred leverage-increasing corporate debt offerings on the market value of the issuing firm’s shares. The main conclusions can be summarized as follows: (1) Straight debt offerings have a non-positive impact on the issuing firm’s common stock price: In the sample of 459 straight debt offerings, excluding mortgage bonds, the average two-day abnormal return relative to the first announcement of the issue in the Wall Street Journal is -0.06%, with a Z-value of - 0.44. The corresponding abnormal performance associated with the issuance of the 189 mortgage bonds in the sample is - 0.20%, with a Z-value of - 1.67. This result is surprising in light of most existing empirical evidence on the valuation effects of leverage-increasing capital structure changes. However, it corroborates a similar conclusion found by Dann and Mikkelson (1984). Given the sample size and the relatively large debt offerings in my sample, this result is also surprising in light of the possibility that the borrowed funds are used to finance new and valuable investment opportunities. For a subsample of offerings by public utilities, I find that the valuation effect of straight debt offerings on average is significantly negatiue when it is announced that the proceeds of the issue will be used to finance the utility’s investment program. In the sample of 86 straight debt offerings by public utilities where the Wall Street Journal article announcing the offering did not contain information on the SEC registration of the issue, the average announcement-period abnormal return is - 0.50%, with a Z-value of - 2.20. 34 of these 86 issues were intended to finance the utility’s capital expenditure program, and the average abnormal return associated with this subsample is - 0.81%, with a Z-value of - 2.62. 19As suggested to me by Merton Miller, it is possible that a model which combines the ‘backward looking’ informational asymmetry of the Miller and Rock (1985) model with the ‘forward looking’ asymmetry of the Myers and Majluf (1984) can explain the various pieces of evidence in this and related papers. I know of no attempt to formally combine the basic assumptions of the two models.

B. E. Eckbo, Valuation effects of corporate debt oferrings

149

(2) Convertible debt offerings have a negative impact on the issuing firm’s common stock price. In the sample of 75 convertible debt offerings, the average two-day abnormal return relative to the first announcement of the issue in the Wall Street Journal is - 1.25%, with a Z-value of - 4.60. Given that the average issue size in the sample is 13% of the market value of common stock, 1.25% negative abnormal return translates into 9.6% of the amount of debt issued, or on average 15 million dollars. This loss is too large to be explained by issue-related transaction costs, and it indicates the presence of a negative information effect analogous to the one observed for stock issues [Asquith and Mullins (1986) Masulis and Korwar (1986)]. This result, which is consistent with the evidence in Dann and Mikkelson (1984) rejects ‘irrelevance’ theories of capital structure which are based on the assumption of informational symmetry between the firm and outside investors. The result is also inconsistent with theories of optimal capital structure which predict that a leverage-increasing capital structure change will cause a positive revaluation of the issuing firm’s equity. The result does not, however, reject the asymmetric information models of Miller and Rock (1985) and Myers and Majluf (1984) both of which predict a negative market reaction to unanticipated external financing. (3) There is no detectable statistical relation between the valuation effect of debt offerings and (i) the size of the offering, (ii) the increase in the firm’s debt-related tax shield, (iii) the rating of the bonds, (iv) the abnormal change in the issuing firm’s earnings in the period immediately following the offering or (v) the offering method. This result holds for both the straight and the convertible debt offerings in the sample. The irrelevance of the size of the offering contrasts with some of the available evidence on common stock offerings and, to the extent that the offering size is a reasonable proxy for the amount of unanticipated new financing, is not predicted by the Miller and Rock (1985) model. The irrelevance of the debt-related tax shield contrasts with the findings of Masulis (1983) who examines exchange offers involving debt for common stock, and of Mikkelson (1983) who studies convertible security calls. The results of this paper suggest that the tax shield effect found by these authors perhaps is a proxy for a more fundamental information effect. The irrelevance of the rating of the bonds in the sample is, under the assumption that Moody’s will not rate an essentially risk-free bond below Aaa, somewhat inconsistent with the Myers and Majluf (1984) model. Furthermore, the evidence does not reject the hypothesis that the valuation effect of a rights offering is equal to the valuation effect of an underwritten offering, a conclusion which is also reached by Dann and Mikkelson (1984). If the rights offerings used in this paper in fact lead shareholders to purchase and hold the new bond issues, then this evidence is

150

B. E. Eckho, Valuation effects of corporate debt offerings

contrary to the Myers and Majluf prediction. Whether this conclusion will continue to hold in a large-sample study of rights offerings is, however, an unsettled issue and is currently being researched. Finally, I find no significant correlation between the sum of the valuation effects of all sample issues of a given firm in a given year and the subsequent abnormal change in the firm’s annual earnings. Thus, although the negative abnormal return associated with the issuance of convertible debt may represent an information effect, there is no evidence to support the proposition that the information concerns a decrease in the firm’s earnings prospects in the years immediately following the issue(s). References Akerlof, G.A., 1970, The market for ‘lemons’: Quality and the market mechanism, Quarterly Journal of Economics 84,488-500. Albrecht, W., L. Lookabill and J. McKeown, 1977, The time-series properties of annual earnings, Journal of Accounting Research 15, 226-244. Asquith, P. and D.W. Mullins, Jr., 1986, Equity issues and offering dilution, Journal of Financial Economics, this issue. Ball, R. and R. Watts, 1972, Some time series properties of accounting earnings numbers, Journal of Finance 27, 663-682. Beaver, W., R. Clarke and W.F. Wright, 1979, The association between unsystematic security returns and the magnitude of earnings forecast errors, Journal of Accounting Research 17, 316-340. Bhagat, S. and A. Hess, 1985, Evidence on the price pressure hypothesis using new issues of seasoned stock, Unpublished paper (University of Utah, Salt Lake City, UT, and University of Washington, Seattle, WA). Bhagat, S., M.W. Marr and G.R. Thompson, 1985, The Rule 415 experiment: Equity markets, Unpublished paper (University of Utah, Salt Lake City, UT, and U.S. Securities and Exchange Commission, Washington, DC). Brennan, M.J. and E.S. Schwartz, 1978, Corporate income taxes, valuation, and the problem of optimal capital structure, Journal of Business 51, 103-114. Dann, L.Y., 1981, Common stock repurchases: An analysis of returns to bondholders and stockholders, Journal of Financial Economics 9, 113-138. Dann, L.Y. and W.H. Mikkelson, 1984, Convertible debt issuance, capital structure change and financing-related information: Some new evidence, Journal of Financial Economics 13,157-186. DeAngelo, H. and R.W. Masulis, 1980, Optimal capital structure under corporate and personal taxation, Journal of Financial Economics 8, 3-30. Donaldson, G., 1961, Corporate debt capacity: A study of corporate debt policy and the determination of corporate debt capacity (Division of Research, Harvard Graduate School of Business Administration, Boston, MA). Galai, D. and R.W. Masulis, 1976, The option pricing model and the risk factor of stock, Journal of Financial Economics 3, 53-81. Hamada, R., 1972, The effects of the firm’s capital structure on the systematic risk of common stocks, Journal of Finance 27, 13-31. Heinkel, R., 1982, A theory of capital structure relevance under imperfect information, Journal of Finance 37, 1141-1150. Jensen, M.C. and W. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, 306-360. Kraus, A. and R. Litzenberger, 1973, A state preference model of optimal financial leverage, Journal of Finance 28, 911-921. Leland, H. and D. Pyle, 1977, Information asymmetries, financial structure and financial intermediaries, Journal of Finance 32, 371-387.

B. E. Eckbo. Valuation effects of corporate debt offerings

151

Masulis, R.W., 1980, The effects of capital structure change on security prices: A study of exchange offers, Journal of Financial Economics 8, 139-178. Masulis, R.W., 1983, The impact of capital structure change on firm value: Some estimates, Journal of Finance 38, 107-126. Masulis, R.W. and A.N. Korwar, 1986, Seasoned equity offerings: An empirical investigation, Journal of Financial Economics, this issue. McConnell, J.J. and C.J. Muscarella, 1985, Corporate capital expenditure decisions and the market value of the firm, Journal of Financial Economics 14, 399-422. McConnell, J.J. and G.G. Schlarbaum, 1981, Evidence on the impact of exchange offers on security prices: The case of income bonds, Journal of Business 54, 65-85. Mikkelson, W.H., 1981, Convertible debt calls and security returns, Journal of Financial Economics 9, 237-264. Mikkelson, W.H., 1985, Capital structure change and decreases in stockholder’s wealth: A cross-sectional study of convertible security calls, in: B.M. Friedman, ed., Corporate capital structures in the United States (University of Chicago Press, Chicago, IL). Mikkelson, W.H. and M. Partch, 1986, Valuation effects of security offerings and the issuance process, Journal of Financial Economics, this issue. Miller, M.H., 1977, Debt and taxes, Journal of Finance 32, 261-275. Miller, M.H. and K. Rock, 1985, Dividend policy under asymmetric information, Journal of Finance 40, 1031-1051. Modigliani, F. and M. Miller, 1958, The cost of capital, corporation finance, and the theory of investment, American Economic Review 48, 261-297. Myers, S.C., 1977, Determinants of corporate borrowing, Journal of Financial Economics 5, 147-175. Myers, S.C., 1984, The capital structure puzzle, Journal of Finance 39, 575-592. Myers, S.C. and N.S. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187-221. Ross, S.A., 1977, The determination of financial structure: The incentive-signalling approach, Bell Journal of Economics 8, 23-40. Smith. C.W., 1977, Alternative methods for raising capital: Rights versus underwritten offerings, Journal of Financial Economics 5, 273-307. Smith, C.W. and J. Warner, 1979, On financial contracts and optimal capital structure: An analysis of bond covenants, Journal of Financial Economics 7, 117-161, Spence, A.M., 1973, Job market signalling. Quarterly Journal of Economics 87, 355-374. Vermaelen, T., 1981, Common stock repurchases and market signalling: An empirical study, Journal of Financial Economics 9, 139-183. Watts, R. and R. Leftwitch, 1977, The time series properties of annual accounting earnings, Journal of Accounting Research 15, 253-271.