The market reaction to seasoned equity issues: Theory and evidence.

Abstract

The anomalous systematic pattern of stock price effects associated with various forms of security issues are well documented. Whereas numerous theories have been put forth to rationalize these empirical findings, our understanding of the determinants generating the observed market response is limited. The issue is compounded as the competing theories of capital acquisition are not mutually exclusive, and their respective market implications are not clearly separable. This paper provides insight into the observed market response by examining how an equity issue alters the division of firm value between existing security classes. To accomplish this objective, the potential redistribution effects are isolated under a perfect capital market assumption. By construction, the competing market effects implied by the asymmetric information, agency relationships, bankruptcy costs and tax based models of capital acquisition are removed from the analysis. An option pricing framework as suggested by Black and Scholes (1973), Galai and Masulis (1976), and Merton (1973,1974) provides the required equilibrium pricing model. Observable market parameters are used to model the wealth effects associated with 85 seasoned equity issues made by industrial firms between 1978 and 1987. On average, the sample exhibits a simulated $-$2.30% stock price effect, a 2.73% bond price effect, and a $-$.201% reduction in bondholder risk premium. The associated market response includes a statistically significant $-$2.62% stock price effect, a.940% bond price effect, and a $-$.184% reduction in bondholder risk premium. Whereas the positive bond and adverse stock price effects documented in this paper are consistent with the redistribution hypothesis, the cross-sectional variation in stock price effects is invariant to issue size, leverage, time to maturity, and bondholder risk premium. In contrast, 11.98% of the cross-sectional variation in bond price effects can be explained by issue size and bondholder risk premium.