An Alternative Explanation of Why and When Firms Issue Equity
Managers are more likely to issue equity to finance projects when they believe investors share their views about the payoffs.
ANN ARBOR, Mich. Firms frequently issue equity when their stock prices are high, but not because their stock is overvalued, says a University of Michigan business professor.
Instead, managers are more likely to issue equity to finance projects when they believe that investors share their views about project payoffs.
"Firms will issue equity when their stock prices are high, but not to exploit mispricing," said Amy Dittmar, assistant professor of finance at the Stephen M. Ross School of Business at the University of Michigan. "Rather, managers regard this situation as the most favorable time to make project-investment decisions that have shareholder approval, because a high stock price indicates to management that investors view the firm and the manager's decisions favorably.
"Thus, anticipated shareholder endorsement is an important driver of management decisions, and this, in turn, determines when equity will be issued."
A new study by Dittmar and colleague Anjan Thakor of Washington University refutes the popular opinion that firms issue equity based on market timing. Proponents of this view contend that firms issue equity when their stock is overvalued because managers believe investors are irrational and, therefore, capital can be raised at an artificially low cost during such times.
Dittmar and Thakor argue that this explanation is flawed because it requires investors to be irrational and managers to have the ability to match the timing of their equity issues with the peaks in their stock prices. Furthermore, they say, market timing fails to explain fully why some firms choose to issue equity, and does not accurately predict the conditions under which such decisions are made.
To find a better explanation of managers' financing choices, the researchers compare 4,496 equity issues and 3,321 non-convertible debt issues made by a sample of firms between 1993 and 2002. Their findings confirm that firms issue equity when their stock prices are high. However, regardless of the stock price, these firms have strong investor agreement with past managerial decisions and, thus, there is greater likelihood investors will support managerial decisions in the future.
Dittmar and Thakor show the relationship between investor agreement and security issuance in a number of ways, including evidence that firms issue equity when they have higher pre-issuance earnings per share relative to analysts' forecasts.
This "agreement parameter" provides an alternative explanation of firms' security-issuance decisions, above and beyond stock-price levels and market timing. Finally, the study shows that after issuing equity, managers significantly increase capital investments, which is not the case for debt issues. This suggests that even when the stock price is high, equity will be issued only to finance a project.
"In a nutshell, our results support our central prediction that anticipated investor endorsement of future investment decisions the manager intends to make is an important determinant of the firm's security-issuance decision," Dittmar said. "Our findings do not rule out market timing as a possible motivation for equity issues, but make a strong case that anticipated investor agreement can explain issuance in circumstances where market timing cannot."
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