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If management is highly concerned about the firm s current stock price, the manager would forgo a
positive NPV project if financing the project required an equity issue, as this would reduce the
price of the stock. Management might also prefer projects with lower NPVs, which pay off
sooner, to higher NPV projects that pay off over a longer time period.

Increasing the debt level can serve as a signal to the market that the firm has favorable future
prospects. Since debt reduces managers flexibility and increases the probability of financial
distress or bankruptcy, only firms with good prospects are willing to take on the extra risk and
costs. Managers signal good prospects by increasing debt because the benefits exceed the costs.
If this is so, the signal is credible.

There are two possible explanations for the fact that stock prices generally respond more
negatively to stock issuance announcements by industrial firms than to announcements by
utilities. The first is that utilities issue equity on a more regular basis and, as a result, the
announcements come as less of a surprise. The second is that utilities are probably subject to less
asymmetric information, implying that an equity issuance is less likely to be viewed as a signal
that utilities are undervalued.

There are a number of reasons why firms tend to invest more when they have more cash available.
Because of personal taxes (see Chapter 15), it may make sense to invest internally generated cash
in marginal projects rather than pay out the cash to shareholders. One can make the same
argument if there are transaction costs associated with raising or paying out capital.
As discussed in Chapter 18, self-interested managers may have an incentive to invest internally
generated cash on marginal projects that benefit the managers personally.
Firms that do not have sufficient cash may pass up positive NPV projects that they would
otherwise fund. This could be because of the underinvestment/debt overhang problem (see
Chapter 16), or because managers are reluctant to issue equity for information reasons, as
discussed in this chapter.
Because managers have superior information relative to outside investors, the manager can take
advantage of his superior knowledge by issuing equity when the stock is overvalued. Outside
investors, knowing this, would take equity issues as a negative signal and discount the stock price
accordingly. As a result, firms may pass up good projects when they cannot finance them either
with cash on hand or by borrowing.

A manager close to retirement puts more weight on the current stock price than does a manager far
from retirement. By selecting a higher debt ratio, the manager signals a higher current stock price
(temporarily) which benefits him either in the form of a glory retirement or a higher stock price
if he sells his holdings of the company. This increased incentive to signal implies that the
manager closer to retirement needs more debt to signal the firm s higher value.

Price with the new project: $620/100=$6.20
To finance the project, ABC must issue $100/$6.20=16.1 new shares.
Subsequent price if ABC finances the new investment:
($1000 + $120)/(100+16.1) = $9.65
Subsequent price if ABC passes up the new investment:
$1000/100 = $10.00
If management wants to maximize the intrinsic value of ABC s shares, they should pass up the
new investment.

When the quality of information improves, it becomes easier for firms to issue outside equity as
well as long-term debt. This is because increased quality of disclosures generally makes it more
difficult for insiders to take actions that expropriate value from outside shareholders and
bondholders. Given this, greater disclosure leads to reductions in equity held by insiders and a
greater use of long-term debt financing.

Managers might sell shares because of portfolio diversification considerations, but the market may
interpret such activity as a signal that managers are pessimistic about the firm s future prospects.
Increasing leverage generally indicates that managers are confident about the future earnings and
performance of the firm. If the two actions occur simultaneously, the former can reduce the
credibility of the signal indicated by the latter. In general, signals are less credible if managers are
seen to have a strong interest in temporarily increasing the firm s stock price. This will be the
case when: the manager plans to sell stock; the manager has stock-based compensation; or, the
firm is a takeover target.

C ash F lows
S tate of the Economy Low Average. High
Management s beliefs $400 $500 $600
Analysts beliefs $300 $400 $500
Cost of distress $100 $150 $200

The intrinsic value is higher if the firm does not incur any cost of financial distress; this is the
case if the debt payments are less than $400. If management places equal weight on intrinsic
value and current value, then management has to take on interest payments up to $500. The
reason is that, even if the analysts are correct about future cash flows, the manager has the
incentive to take on debt of $400 to boost the current stock price, while sacrificing some of the
intrinsic value of the firm through greater financial distress costs.
S tate: Low High

Cash $100 $100
Fixed asset value $200 $300
Growth opportunity NPV $100 $100

The answer depends on investors beliefs. Assume that investors believe that the firm issues
equity only when the firm s fixed assets equal $200. We will show that these beliefs are self-
If the firm is in the high state:
Do nothing:
value of original equity = $100 + $300 = $400
Issue riskless debt to finance the project:
value of original equity = $100 + $300 + $100 = $500
[Since I = $200 < ($100 + $200), the debt is riskless in both states]
Issue equity:
value of original equity = ($300/$400) × $600 = $450

Therefore, the firm prefers to finance the project with debt. If it can not issue debt, the firm is
better off issuing equity and taking the project.

Since Mr. Smith cares more about intrinsic value while Mr. Chan cares more about current stock
price, Mr. Smith s announcement is more credible. Therefore, Mr. Smith s firm should expect
the greater stock price increase.

Since the warrants are a bet against the firm, the outside investor should become less optimistic
about Hopewell s future profits. Warrants are more valuable when volatility is higher; therefore,
the incentive to issue warrants is higher when volatility is expected to be low.

Increasing leverage with exchange offers signals to the market that management is confident about
the future performance of the firm. Consequently, stock prices generally increase.

a. If the firm is fairly valued, management should probably issue equity since this is a risky
business and, for the reasons discussed in Chapter 17, the firm requires a relatively low debt ratio
in order to sell its high-tech farm equipment.

b. If the firm is slightly undervalued, management may choose to issue convertible bonds. As
mentioned in (a), the firm has an incentive to issue equity, but may choose to avoid doing so if
its equity is sufficiently underpriced. Convertible debt is also underpriced in this situation, but
not as much as the firm’s equity.

c. If the firm’s equity is substantially undervalued, its convertible debt will also be undervalued.
To avoid the dilution costs associated with selling an undervalued security, the firm may choose
to take out a bank loan. However, this is a risky strategy; if the firm does poorly, and therefore
has difficulty meeting its debt obligations, the firm’s ability to attract new customers will
deteriorate which will in turn worsen the firm’s financial situation.


The stock price increase does not necessarily indicate that the market viewed the dividend increase
as a good decision. The direct impact of a dividend increase may decrease the after-tax returns to
shareholders. But the information content of a dividend increase may reveal favorable information
about the firm s future cash flows.

Since managers are usually replaced following a hostile takeover, management wants to reduce the
probability of a hostile takeover. If the probability of a hostile takeover decreases as the firm s
share price increases, management is more willing to take short-sighted actions that temporarily
increase share price when there is a threat of hostile takeover.

Since default wold occur in two of the three demand scenarios, a debt obligation above $400
million will result in a gain in firm value of only [$50 million − (2/3)$60 million] = $10
million. As shown in Example 19.7, the firm obtains a higher value with less than $400 million
in debt.