New Equity Sales And The Value Of The Firm

We now turn to a consideration of seasoned offerings, which, as we discussed earlier, are offerings by firms that already have outstanding securities. It seems reasonable to believe that new long-term financing is arranged by firms after positive net present value projects are put together. As a consequence, when the announcement of external financing is made, the firm's market value should go up. Interestingly, this is not what happens. Stock prices tend to decline following the announcement of a new equity issue, although they tend to not change much following a debt announcement. A number of researchers have studied this issue. Plausible reasons for this strange result include the following:

1. Managerial information. If management has superior information about the market value of the firm, it may know when the firm is overvalued. If it does, it will attempt to issue new shares of stock when the market value exceeds the correct value. This will benefit existing shareholders. However, the potential new shareholders are not stupid, and they will anticipate this superior information and discount it in lower market prices at the new-issue date.

2. Debt usage. A company's issuing new equity may reveal that the company has too much debt or too little liquidity. One version of this argument says that the equity issue is a bad signal to the market. After all, if the new projects are favorable ones, why should the firm let new shareholders in on them? It could just issue debt and let the existing shareholders have all the gain.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

16. Raising Capital

© The McGraw-Hill Companies, 2002

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