Smith (1986) Raising Capital

1
Smith (1986) Raising Capital

• Table 1 Stock markets reaction to announcements
  of security offerings of various types
• Industrial/HI Growth Utility/LOW
  Growth
• Common stock -3.14 -0.75
• Preferred stock -0.19 0.08
• Convertible pref. stock -1.44 -1.38
• Straight bonds -0.26 -0.13
• Convertible bonds -2.07 --
• statistically insignificant

2

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

3

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

4

• Debt-Value Function Movements along the curve.
• D0 to D1 Issuing equity. Company value goes
  down. Consistent with empirical evidence.
• D0 to D2 Issuing debt Company value goes down
  Evidence inconsistent with data.

V0
Value of Company
V1
V2
D1
D0
D2
Debt/Total Capital
5

• Debt-Value Function Shift of the curve.
• Movements along the leverage value function
  cannot be differentiated from shifts in the
  function.
• Hence, hypothesis is not very useful.

V0
Value of Company
V1
V2
D1
D0
D2
Debt/Total Capital
6

• Implied Changes in Net Operating Cashflow
• Firms cashflow identity
• Market is trying to estimate net income by
  assuming only one other variable in the equation
  changes and the other four stay constant.
• Table 2 Implied increase (decrease) in net
  income increases (decreases) share price.

New debt New equity Net income Interest
payment Dividend New investment
7

• Table 2 Implied increase (decrease) in net
  income increases (decreases) share price.
• Type of Announcement 2-day Return ()
• Implied INCREASE in expected cashflow
• Common Stock Repurchases
• Intra-firm tender offer 16.2
• Open mkt. Repurchase 3.6
• Dividend Increases
• Dividend initiation 3.7
• Dividend increase 0.9
• Special dividends 2.1
• Investment increases 1.0

8

• Table 2 Implied increase (decrease) in net
  income increases (decreases) share price.
• Type of Announcement 2-day Return ()
• Implied DECREASE in expected cashflow
• Security sales
• Common stock -1.6
• Preferred stock 0.1
• Convertible preferred -1.4
• Straight debt -0.2
• Convertible debt -2.1
• Dividend decreases -3.6
• Investment decreases -1.1

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

10

• Information Asymmetry
• Market analysts are less well-informed about a
  firms intrinsic value than managers.
• Managers will issue equity if
• Funds are needed to finance a very high positive
  NPV project.
• Firms stock is overvalued in the market.
• Market assumes that managers are issuing equity,
  because the stock is overpriced.
• Explains negative market reaction to equity
  offerings.

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

12

• Information Asymmetry (continued)
• Since debt and preferred stock are more senior
  claims to equity, their value is less sensitive
  to changes in firm value.

Value of Debt Claim
X
Firm Value
Value of Equity Claim
X Face Value of Debt
X
Firm Value
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• Two hypotheses explain most of the markets
  reaction to new security offerings.
• Implied Changes in Net Cashflow
• Information Asymmetry