Chapter 31 Seasoned Equity Offerings A Survey

R. Jarrow et al., Eds.
, Handbooks in OR & MS, VoL 9

© 1995 Elsevier Science B.V. All rights reserved
Chapter 31
Seasoned Equity Offerings: A Survey
B. Espen Eckbo
Faculty of Commerce and Business Administration, University of British Columbia, Vancouver,
B.C. V6T 1Y8, Canada
Ronald W. Masulis
Owen Graduate School of Management, Vanderbilt University, Nashville, TN 37203, US.A.
1. Introduction
Corporate securities are issued through a wide variety of methods, often

involving complex contractual arrangements. While we do not yet have a unified
theory of the capital acquisition process, our understanding of these contractual
arrangements and their impact on firm value has progressed substantially over
the past decade. In this paper, we review the theory and statistical evidence
concerning the causes and effects of seasoned public offers (SPOs) of common
stock, 1 with particular emphasis on results and findings that post-date the well
known survey by Smith (1986) up to 1994. In fact, recent studies now provide
at least partial answers to several of the 'unresolved issues' listed by Smith at
the end of his survey. These include (i) to what extent does the market reaction
to issue announcements depend on the flotation method; (ii) the conditions that
lead issuers to select uninsured rights or rights with standby underwriting over
a firm commitment underwritten offer; (iii) why rights issues continue to be
the predominant flotation method in many foreign jurisdictions while they have
become virtually extinct in the U.S.; and (iv) the determinants of direct and
indirect flotation costs across flotation methods. In addition, we review (v) recent
trends in aggregate issue activity; (vi) the timing of individual equity issues; and
(vii) market microstructure effects of equity offers.
We begin in Section 2 by showing trends in aggregate issue activity across
common stock, preferred stock, and corporate bonds in the U.S. over the last
50 years. This serves to place the relative importance of seasoned common stock
issues in its proper historical perspective. Section 2 also compares recent trends in
equity issue activity in the U.S. with those of Canada, Europe and Japan.
Section 3 describes the most frequently used flotation methods and shows
their relative aggregate frequencies beginning in 1935. Section 3 then goes on to
1 Initial public offers (IPOs) are discussed in Ibbotson & Ritter [1995, this volume].
1017
1018 B.E. Eckbo, R.W. Masulis
examine available evidence on direct and indirect costs for three major flotation
methods: uninsured rights, standby rights and firm commitment underwritten
offers. Multivariate regressions strongly indicate that rights issues have the lowest
direct flotation cost, firm commitment underwritten offers the highest, while
standby rights offers are in between. In light of this, the overwhelming preference
for the apparently expensive firm commitment flotation method must reflect either
additional indirect costs which decrease the attractiveness of rights and standbys
or, alternatively, a managerial incentive problem in choosing the optimal flotation
method. Section 3 discusses a number of indirect costs, including personal taxes,
shareholder borne transaction costs of selling rights, costs of rights offering failure,
and anti-dilution clause mandated wealth transfers to convertible security holde/s
triggered by rights issues. However, there is insufficient evidence to conclude that
these indirect costs explain the low frequency of rights in the U.S.
Section 4 discusses the valuation effects of seasoned equity offers across flota-
tion methods. The major theoretical arguments are based on adverse selection
and signalling effects associated with information asymmetries, agency costs of
free cash flow, wealth transfers between classes of security holders, as well as
moral hazard problems in lowering managerial stock ownership. We review the
large body of empirical evidence in this area, including stock price effects of SPO
announcements by: flotation method, type of securities issued, and classified by
offer completion or withdrawal. Available evidence on nonpublic seasoned equity
offers is also integrated into the analysis of this section.
Section 5 discusses models of the flotation method choice (rights vs. underwrit-
ing, best effort vs. firm commitment) which explicitly recognize information asym-
metries between the issuer and the market. Section 6 surveys recent theories and
evidence on the correlation between issue activity, the stock price pattern prior to
the issue announcement, and the business cycle, while Section 7 discusses potential
market microstructure effects of SPOs. Concluding remarks are made in Section 8.
2. Trends in aggregate corporate financing activity
2.1. Debt vs. equity
Corporations raise capital through internal sources of equity (retained earnings

plus depreciation) and external sales of securities and other financial claims.
Table 1 shows the proportions of total funds accounted for by internal equity and
external equity and debt sources for U.S. nonfinancial corporations after World
War II. The table strongly indicates that retained earnings is the dominant funding
source, followed by debt security issuance. 2
It should be noted that since debt must be refinanced at maturity, and part of
the debt is convertible into equity, Table 1 is biased in favour of finding a higher
2 This trend persists also when debt values are reduced to take into account the effect of
inflation.
Ch. 31. Seasoned Equity Offerings: A Survey 1019
Table 1
S o u r c e s o f f u n d s f o r U.S. n o n f a r m , n o n f i n a n c i a l c o r p o r a t e business, 1946-1991 a
Year Total Retained Depreciation Bonds & Short-term Other debt Equity offers
funds earnings mortgages debt
($bill.) ($bill.) (%) ($bill.) (%) ($bilL) (%) ($bill.) (%) ($bill.) (%) ($bill.) (%)
1946 19.3 8.8 45.6 -0.2 -1.0 2.6 13.5 3.3 17.1 3.8 19.7 1.0 5.2
1947 27.6 13.1 47.5 0.3 1.1 4.3 15.6 3.0 10.9 5.8 21.0 1.1 4.0
1948 29.4 14.4 49.0 5.2 17.7 5.7 19.4 -0.2 -0.7 3.3 11.2 1.0 3.4
1949 20.5 9.8 47.8 10.2 49.8 3.7 18.0 -1.8 -8.8 -2.6 -12.7 1,2 5.9
1950 42.5 14.4 33.9 4,1 9.6 2.9 6.8 3.9 9.2 15,9 37,4 1.3 3.1
1951 37.0 11.4 30.8 9.4 25.4 4.3 11.6 4.1 11.1 5.7 15.4 2.1 5.7
1952 3.04 9.7 31.9 12.8 42.1 5.7 18.8 1.5 4.9 -L6 -5.3 2.3 7.6
1953 28.7 9.8 34.1 12.6 43.9 4.4 15.3 -0.4 -1.4 0.5 1.7 1.8 6.3
1954 30.0 9.5 31.7 14.9 49.7 5.1 17.0 -0.3 -1.0 -0.8 -2.7 1.6 5.3
1955 53.4 14.2 26.6 15.7 29.4 4.9 9.2 3.8 7.1 13.1 24.5 1.7 3.2
1956 45.1 13.7 30.4 16.2 35.9 5.1 11.3 5.3 11.8 2.5 5.5 2.3 5.1
1957 43.5 12.7 29.2 19.3 44.4 7.6 17.5 1.8 4.1 -0.3 -0.7 2.4 5.5
1958 42.3 9.0 21.3 21.6 51.1 8.5 20.1 0.0 0.0 1.2 2.8 2.{} 4.7
1959 56.6 13.3 23.5 23.0 40.6 6.2 11.0 4.2 7.4 7.8 13.8 2.1 3.7
1960 48.8 11.1 22.7 24.7 50.6 6.0 12.3 4.4 9.0 1.2 2.6 1.4 2.9
1961 56.1 10.5 18.7 26.5 47.2 8.4 15.0 1.7 3.0 6.9 12.3 2.1 3.7
1962 60.2 13.3 22.1 29.9 49.7 8.6 14.3 3.5 5,8 4.5 7.5 0.4 0.7
1963 68.6 15.1 22.0 31.9 46.5 8.5 12.4 3.9 5.7 9.5 13.8 -0.3 -0.4
1964 74.1 19.1 25.8 33.3 44.9 6.7 9.0 5.9 8.0 8.0 10.8 1.1 1.5
1965 93.0 23.8 25.6 35.4 38.1 7.6 8.2 11.4 12.3 14.8 15.9 0.0 0.0
1966 98.3 25.7 26.1 37.6 38.3 13.0 13.2 9.5 9.7 11.2 11.4 1.3 1.3
1967 95.0 22.8 24.0 41.5 43.7 16.8 17.7 8.1 8.5 3.4 3.6 2.4 2.5
1968 114.5 22.7 19.8 43.0 37.6 15.1 13.2 13.0 11.4 20.9 18.3 -0.2 -0.2
1969 117.9 19.9 16,9 45.3 38.4 11.2 9.5 19.2 16.3 18.9 16.0 3.4 2.9
1970 102.5 14.6 14.2 48.3 47.1 20.7 20.2 7.9 7.7 5.3 5.2 5.7 5.6
1971 I26.4 20.4 16.1 54.3 43.{} 21.4 16.9 4.3 3.4 14.5 11.6 11.4 9.0
1972 153.2 27.4 17.9 58.9 38.4 15.5 10.1 17.4 11.4 23.1 15.1 10.9 7.l
1973 195.7 43.3 22.1 50.6 25.9 12.9 6.6 36.9 18.9 44.1 22.5 7.9 4.0
1974 194.2 51.1 26.3 38.2 19.7 22.3 11.5 43.9 22.6 34.6 17.8 4.1 2.1
1975 158.3 50.8 32.1 74.0 46.7 28.6 1 8 . 1 -11.5 -7.3 6.5 4.1 9.9 6.3
1976 219.1 65.1 29.7 76.9 35.1 37.8 12.7 16.7 7.6 22.1 10.1 10.5 4.8
1977 261.4 76.7 29.3 88.3 33.8 33.3 12.7 36.1 13.8 24.3 9.3 2.7 1.0
1978 328.7 89.1 27.1 93,2 28.4 33.4 10.2 51.8 15.8 61.3 18.6 -0.1 0.0
1979 352.7 105.2 29.8 92.4 26.2 28,8 8.2 66.9 19.0 67.2 19,1 -7.8 -2.2
198{) 337.2 104.2 30.9 111.9 33.2 17.5 5.2 40.7 12.1 52.5 15.6 10.4 3.1
1981 409.3 93.4 22.8 160.6 39,2 55.7 13.6 67.2 16.4 46.0 11.2 -13.5 -3.3
1982 371.9 58.5 15.7 205.2 55.2 36.2 9.7 54.7 14.7 15.4 4.1 1.9 0.5
1983 452.9 6.9 13.4 243.1 53.7 35.5 7.8 35.5 7.8 57.9 12.8 20.0 4.4
1984 532.4 77.6 14.6 270.2 50.8 95.6 18.0 105.5 19.8 62.5 ll.7 -79.0 -14.8
1985 484.9 52.6 10.8 310.5 64.0 89.4 18.4 57.0 11.8 59.9 12.4 -84,5 -17.4
1986 597.8 30,9 5.2 322.7 54.0 205.4 34.4 65.8 11.0 58,0 9.7 -85.0 -14,2
1987 569.2 8{}.9 14.2 309.9 54.4 112.5 19.8 35.4 6.2 106.0 t8.6 -75.5 -13.3
1988 652.0 122.7 18.8 310.9 47.7 152.8 23.4 75.9 11.6 199.2 18.3 -129.5 -19.9
1989 603.1 102.3 17.0 320.9 53.2 118.0 19.6 83.8 13.9 102.3 17.0 -124.2 -20.6
1990 489.3 84.8 17.3 313.7 64.1 51.3 10.5 29.9 6.1 72.6 14.8 -63.0 -12.9
1991 469.1 69.0 14.7 337.1 71.9 62.1 13.2 -58.0 12.4 41.4 8.8 17.5 3.7
a S o u r c e : F l o w of F u n d s , B o a r d o f G o v e r n o r s of the F e d e r a l R e s e r v e A c c o u t s , S e a s o n a l l y A d j u s t e d
Flows, ' N o n - F i n a n c i n g C o r p o r a t e Business Excluding F a r m s ' .
1020 B.E. Eckbo, R. W. Masulis
Table 2
Leverage ratios for U.S. corporations, 1926-1986 ~
Year All U.S. corporations Manufacturing corporations

Debt/ Long-term debt/ Debt/ Long-term debt/ Debt/
total assets long-term capital total assets long-term capital total assets
1926 - 0.21 - 0.09 -

1927 - 0.22 - 0.09 -
1928 - 0.23 - 0.10
1929 0.13 0.23 - 0.09 -
1930 0.18 0.24 - 0.10

1931 0.25 0.25 - 0.10
1932 0.39 0.26 - 0.11
1933 0.37 0.26 - 0.10
1934 0.32 0.26 - 0.10
1935 0.36 0.26 - 0.10 -
1936 0.24 0.26 - 0.10
1937 0.27 0.26 0.53 0.10 0.26
1938 0.41 0.27 0.54 0.11 0.25
1939 0.32 0.27 0.55 0.11 0.25
1940 0.33 0.26 0.57 0.11 0.27

1941 0.38 0.26 0.58 0.11 0.31
1942 0.44 0.24 0.61 0.10 0.35
1943 0.28 0.23 0.63 0.09 0.36
1944 0.28 0.23 0.64 0.09 0.34
1945 0.25 0.21 0.65 0.09 0.30
1946 0.16 0.21 0.64 0.10 0.30
1947 0.17 0.22 0.63 0.11 0.31
1948 0.17 0.23 0.62 0.12 0.32
1949 0.23 0.23 0.62 0.12 0.28
1950 0.18 0.23 0.63 0.11 0.31

1951 0.19 0.23 0.63 0.13 0.35
1952 0.21 0.24 0.65 0.15 0.36
1953 0.21 0.25 0.64 0.15 0.36
1954 0.22 0.25 0.65 0.15 0.34
1955 0.16 0.24 0.66 0.15 0.35
1956 0.15 0.25 0.65 0.16 0.36
1957 0.17 0.26 0.65 0.17 0.37
1959 0.16 0.27 0.66 0.17 0.38
1960 0.18 0.27 0.66 0.17 0.38

196l 0.16 0.28 0.66 0.18 0.43
1962 0.21 - - -
1963 0.18 0.28 0.68 0.17 0.38
1964 0.17 0.28 0.68 0.18 0.39
1965 0.17 0.28 0.69 0.19 0.40
1966 0.22 0.29 0.69 0.21 0.43
1967 0.19 0.29 0.69 0.21 0.42
1968 0.18 0.30 0.70 0.23 0.45
1969 0.22 0.31 0.70 0.23 0.45
Table 2 (cont'd)
Year All U.S. corporations Manufacturing corporations

Debt/ Long-term debt/ Debt/ Long-term debt/ Debt/
total assets long-term capital total assets long-term capital total assets
1970 0.27 0.32 0.71 0.26 0.49
1971 0.26 0.33 0.72 0.27 0.69
1972 0.24 0.33 0.72 0.26 0.49
1973 0.3l 0.34 0.73 0.26 0.51
1974 0.38 0.34 0.74 0.27 0.53
1975 0.32 0.34 0.74 0.28 0.52
1976 0.32 0.34 0.74 0.28 0.53
1977 0.34 0.34 0.74 0.27 0.53
1978 0.35 0.34 0.75 0.28 0.54
1979 0.36 0.33 0.74 0.28 0.55
1980 0.32 0.33 0.74 0.28 0.56
1981 0.29 0.32 0.73 0.28 0.56
1982 0.29 0.33 0.73 0.29 0.56
1983 0.26 0.33 0.74 0.28 0.57
1984 0.27 0.34 0.74 0.29 0.57
1985 0.30 0.33 0.74 0.29 0.58
1986 0.31 0.35 0.74 0.34 0.62
1987 - 0.35 0.74 0.35 0.62
1988 - 0.36 0.75 0.37 0.63
a Source: Masulis [1988, updated]. The sources in the original study include Taggart
[1985], Holland & Myers [197911 and the Statistics of Income, Corporation Returns,
Table 2. All figures are in book value terms except for column 2 (Debt/total assets)
which is an estimate of the leverage ratio using market value data.
p r o p o r t i o n of d e b t than equity issues. A firm issuing $100 w o r t h of equity to

finance the next fifty years of i n v e s t m e n t will a p p e a r as having issued equity once
at the level of $100 over the 50-year period. In contrast, if the same firm rolls
over five 10-year bonds, Table 1 will r e c o r d five debt issues e a c h worth a r o u n d
$100 o v e r the s a m e t i m e period. W h i l e it is difficult to control for the resulting
d o u b l e counting, E c k b o [1986] reports that approximately 40% o f a sample of 650
c o r p o r a t e debt issues by publicly t r a d e d firms over the p e r i o d 1963-1981 were for
the p u r p o s e of r e f u n d i n g old debt (including r e t i r e m e n t of outstanding bonds and
c o n v e r s i o n of b a n k loans and c o m m e r c i a l p a p e r to bonds). Based on this, a rough
a d j u s t m e n t would be to r e d u c e the debt p r o p o r t i o n by o n e half, which would leave
u n a l t e r r e d the c o n c l u s i o n that debt constitutes the p r e d o m i n a n t external funding
source in the post-war period.
T h e e v i d e n c e in Table 1 can be s u m m a r i z e d as follows:
O b s e r v a t i o n 1 Corporate funding sources,

(i) I n t e r n a l equity has r e m a i n e d the d o m i n a n t funding source for U.S. nonfinan-
cial c o r p o r a t i o n s after the second world war.
(ii) Debt dominates equity as an external funding source, with a net retirement
of equity in the 1980s.
(iii) In periods with low internally generated equity, the proportion of debt
financing tends to increase to finance the shortfall. In periods with high
internal equity, debt issues tend to be used to retire external equity.
The relative increase in debt financing witnessed since the second world war is
also apparent from the time series of debt to asset ratios in Table 2:
Observation 2 Leverage ratios'. Leverage (debt to total asset) ratios for U.S.
manufacturing companies have increased steadily over the post-war period from a
low of 30% in 1946 to approximately 60% in 1984.
Models of optimal capital structure predict that a number of economy wide

variables will effect the debt to asset ratio, including tax rates, interest rates and
business cycles. Consistent with this, Taggart [1985] also observes that corporate
debt appears to rise in periods of rising corporate tax rates, especially when
not offset by rising personal tax rates and in periods when corporate nondebt
deductions were falling due to inflation. Increases in equity appear to be deterred
by increased volatility in economic conditions.
2.2. Public security offerings for cash
Table 3 presents the dollar volume of annual public and private offerings of
common stock, preferred stock and corporate bonds in the U.S. from 1938 through
1991. An interesting aspect of the data is the low average frequency of common
stock and especially preferred stock offers. The table also shows substantial
variation across time in both the size of aggregate security offerings and the
proportion of total funds raised by equity. What are the sources of this variability?
Based on U.K. data, Marsh [1982] reports that the debt-equity choice can partially
be predicted by the tendency of firms' short term and long term debt and retained
earnings levels to move toward their historical levels. In the U.S., Taggart [1977]
and Choe, Masulis & Nanda [1993] report that equity issues are more frequent in
upswings of the business cycle and when stock price volatility is relatively low. In
contrast, nonconvertible debt tends to be relatively more frequent in downturns of
the business cycle and when stock market volatility is relatively high.
Table 3 also indicates that the proportion of public sales of securities has
historically been substantially higher than the proportion of private placements in
the U.S.. This trend appears to have changed towards the end of the 1980s, as the
dollar volume of private sales has approached the volume of public offers for both
debt and equity.
Observation 3 Offer frequencies.

(i) The ratio of public equity to public debt issues tends to increase during
business cycle expansions and to decrease during business cycle contractions.
Table 3
U.S. corporate securities offerings for cash, 1938-1991 ($ millions)a
Year Total Corporate bonds Prfd. stock Common stock
issues
Total % Public Private Sold Public % Total % Public Private
bonds of domes- domes- abroad of com- of
total tic tic total mon total
1938 2,t55 2,044 94.9 1,353 691 0 86 4.0 25 1.2 25 0
1939 2,164 1,979 91.5 1,276 703 0 98 4.5 87 4.0 87 0
1940 2,677 2,386 89.l 1,628 758 0 183 6.8 108 4.0 108 0
1941 2,666 2,389 89.6 1,578 811 0 167 6.3 110 4.1 110 0
1942 1,063 917 86.3 506 411 0 112 10.5 34 3.2 34 0
1943 1,170 990 84.6 621 369 0 124 i0.6 56 4.8 56 11
1944 3,202 2,670 83.4 1,892 778 0 369 11.5 163 5.1 163 0
1945 6,010 4,855 80.8 3,851 1,004 0 758 12.6 397 6.6 397 0
1946 6,898 4,881 70.8 3,019 1,862 0 1,126 16.3 891 12.9 891 0
1947 6,574 5,035 76.6 2,888 2,147 0 761 11.6 778 11.8 778 0
1948 7,079 5,973 84.4 2,963 3,010 0 492 7.0 614 8.7 614 0
1949 6,049 4,889 80.8 2,434 2,455 0 424 7.0 736 12.2 736 0
1950 6,362 4,920 77.3 2,360 2,560 0 631 9.9 811 12.7 811 0
1951 7,740 5,690 73.5 2,364 3,326 0 838 10.8 1,212 15.7 1,212 0
1952 9,535 7,602 79.7 3,645 3,957 0 564 5.9 1,369 14.4 1,369 0
1953 8,899 7,084 79.6 3,856 3,228 0 489 5.5 1,326 14.9 1,326 0
1954 9,516 7,487 78.7 4,003 3,484 0 816 8.6 1,213 12.7 1,213 0
1955 10,240 7,420 72.5 4,119 3,301 0 635 6.2 2,185 21.3 2,185 I/
1956 10,939 8,002 73.2 4,225 3,777 0 636 5.8 2,301 21.0 2,301 0
1957 12,884 9,957 77.3 6,118 3,839 0 411 3.2 2,516 19.5 2,516 0
1958 11,557 9,652 83.5 6,332 3,320 0 571 4.9 1,334 11.5 1,334 0
1959 9,747 7,189 73.8 3,557 3,632 0 531 5.4 2,027 20.8 2,027 0
1960 10,154 8,081 79.6 4,806 3,275 0 409 4.0 1,664 16.4 1,664 I/
1961 I3,164 9,420 71.6 4,700 4,720 0 450 3.4 3,294 25.0 3,294 0
1962 10,705 8,969 83.8 4,440 4,529 0 422 3.9 1,314 12.3 1,314 0
1963 12,236 10,872 88.9 4,714 6,158 0 342 2.8 1,022 8.4 1,022 0
1964 13,957 10,866 77.9 3,623 7,243 0 412 3.0 2,679 19.2 2,679 0
1965 15,992 13,720 85.8 5,570 8,150 0 725 4.5 1,547 9.7 1,547 0
1966 18,073 15,560 96.1 8,018 7,542 0 574 3.2 1,939 10.7 1,939 0
1967 24,798 21,954 88.5 14,990 6,964 0 885 3.6 1,959 7.9 1,959 l)
1968 21,966 17,383 79.1 10,732 6,651 0 637 2.9 3,946 18.0 3,946 0
1969 26,743 18,347 68.6 12,734 5,613 0 682 2.6 7,714 28.8 7,714 0
1970 38,945 30,315 77.8 25,384 4,931 0 1,390 3.6 7,240 1 8 . 6 7,240 0
1971 45,/1911 32,129 71.3 24,775 7,354 0 3,670 8.1 9,291 2 0 . 6 9,291 0
1972 40,226 26,131 65.0 17,425 8,706 0 3,370 8.4 10,725 2 6 . 7 10,725 0
1973 32,025 21,046 65.7 13,244 7,802 0 3,337 1 0 . 4 7,642 2 3 . 9 7,642 0
1974 38,310 32,063 83.7 25,903 6,160 0 2,253 5.9 3,994 1 0 . 4 3,994 0
1975 53,618 42,755 79.7 32,583 10,172 0 3,458 6.4 7,405 1 3 . 8 7,405 0
1976 53,488 42,380 79.2 26,453 15,927 0 2,803 5.2 8,305 1 5 . 5 8,305 0
1977 54,206 42,193 77.8 24,186 18,007 0 3,878 7,2 8,135 1 5 . 0 8,135 0
t978 47,230 36,872 78.1 19,815 17,057 0 2,832 6,0 7,526 1 5 . 9 7,526 0
1979 51,533 40,208 78.0 25,814 14,394 0 3,574 6,9 7,751 1 5 . 0 7,751 l/
1980 73,695 53,206 72.2 41,587 11,619 0 3,631 4,9 16,858 22.9 16,858 0
1981 70,441 45,092 64.0 38,103 6,989 0 1,797 2,6 23,552 33.4 23,552 0
1982 84,638 54,076 63.9 44,278 9,798 0 5,113 6,0 25,449 30.1 25,449 0
1983 120,074 68,495 57.0 47,369 21,126 0 7,213 6.0 44,366 36.9 44,366 0
1984 132,311 109,683 82.9 73,357 36,326 0 4,118 3,1 18,510 14.0 18,510 0
1985 239,055 203,540 85.1 119,559 46,200 37,781 6,505 2,7 29,010 12.1 29,010 0
1986 423,725 355,292 83.8 231,936 80,760 42,596 11,514 2,7 56,919 13.4 50,316 6,603
1987 392,671 326,166 83.1 209,790 92,070 24,306 10,123 2.6 56,382 14.4 43,225 13,157
1988 410,893 353,092 85.9 202,215 127,699 23,178 6,544 1,6 51,257 12.5 35,911 15,346
1989 378,760 320,889 84.7 180,618 177,420 22,851 6,194 L6 51,677 13.6 26,030 25,647
1990 340,126 229,959 8 8 . 2 189,917 86,988 23,054 3,998 1.2 36,169 10.6 19,433 16,736
Source: Federal Reserve Bulletin, New Security Issues.
1024 B.E. Eckbo, R.W.. Masulis
(ii) U n t i l t h e s e c o n d h a l f o f t h e 1980s, o n l y a s m a l l f r a c t i o n o f s e c u r i t y i s s u e
v o l u m e in t h e U . S . was s o l d privately. H o w e v e r , r e c e n t y e a r s h a v e s e e n a
s u b s t a n t i a l i n c r e a s e in p r i v a t e p l a c e m e n t v o l u m e .
2.3. International trends
T a b l e 4 s h o w s t h e m a j o r f i n a n c i n g s o u r c e s f o r n o n f i n a n c i a l c o m p a n i e s in
C a n a d a , F i n l a n d , F r a n c e , G e r m a n y , Italy, J a p a n , t h e U . K . a n d t h e U . S . o v e r t h e
1 9 7 0 - 1 9 8 5 p e r i o d . T h e t a b l e , w h i c h o r i g i n a l l y a p p e a r e d in M a y e r [1990], i n d i c a t e s
several interesting aspects concerning the corporate financing strategies across
these countries.
Table 4
Average financing of nonfinancial enterprises, in percent of total financing sources, 1970-1985 a
Canada b Finland c France Germany d Italy e Japan f United United

Kingdomg States h
Retentions 54.2 42.1 44.1 55.2 38.5 33.7 72.0 66.9

Capital transfers 0.0 0.1 1.4 6.7 5.7 0.0 2.9 0.0
Short-term securities 1.4 2.5 0.0 0.0 0.1 N.A. 2.3 1.4
Loans 12.8 27.2 41.5 21.1 38.6 40.7 21.4 23.1
Trade credit 8.6 17.2 4.7 2.2 0.0 18.3 2.8 8.4
Bonds 6.1 1.8 2.3 0.7 2.4 3.1 0.8 9.7
Shares 11.9 5.6 10.6 2.1 10.8 3.5 4.9 0.8
Other 4.1 6.9 0.0 11.9 1.6 0.7 2.2 -6.I
Statistical adjustment 0.8 -3.5 -4.7 0.0 2.3 N.A. -9.4 -4.1
Total 99.9 99.9 99.9 99.9 99.9 100.0 99.9 100.1
a Source: Mayer [1990]. The original data are constructed from OECD flow-of-funds statistics. The
footnotes below are from the original table.
b For Canada, mortgages are included in loans, foreign investments are included in other, and
capital transfers are included in retentions.
c Data o n Finland refer to the period 1969-1984. Errors in the OECD statistics have required that
the statistical adjustment be altered as follows: 1971, DM 2 billion and 1973, +DM 89 billion.
d There is no statistical adjustment in German accounts. Funds placed with insurance companies
and building and loans associations are included in loans.
e The Italian statistical adjustment has been reduced by Lit 2.070 billion in 1974 to make accounts
balance. Trade credit is not recorded as a separate item in Italian flow-of-funds.
t"Japanese flow-of-funds do not report retentions. The ratio of external to internal financing of
Japanese enterprises was obtained by applying proportions recorded in aggregate company accounts
for the period 1972-1984, as shown in Table 12 (IV and V). The Japanese figures therefore have
to be treated with particular caution. Short-term securities are included in bonds.
g United Kingdom statistics refer to private enterprises only; were public enterprise to be included
then entries would read as follows: retentions, 91.9; capital transfers, 5.7; short-term securities, 1.3;
loans, 11.7; trade credit, -0.7; bonds, -0.9, shares, 2.5; other, 2.1; statistical adjustment, -8.5.
h The following modifications have been made to the U.S. statistical adjustment to make accounts
balance (in millions of dollars): 1970, -1; 1971, -3; 1973, +3; 1975, +1; 1976, -2; 1979, +2; 1981,
-1; 1982, +1; 1983, -2; 1984, 1. Capital transfers are included under retentions in U.S. accounts.
Acquisitions of central government short-term securities are not shown separately from bonds.
Ch. 31. Seasoned Equity Offerings:A Survey 1025
Observation 4 International funding sources.

(i) Retained earnings are the major source of finance in all the industrial
countries studied.
(ii) The proportion of external funding is largest in Finland, France, Japan and
Italy.
(iii) Banks are the dominant source of external finance in all countries, represent-
ing approximately 40% of gross sources in France, Italy and Japan.
(iv) Companies in Canada, France and Italy are the largest users of external
capital markets, with short-term securities, bonds and shares representing
19%, 13% and 13% of gross financing, respectively.
(v) Canadian, French and Italian firms raise approximately 10% of their gross
financing by issuing equity, while the corresponding proportion is less than
5% in Germany, Japan and the U.S..
Over the 1970-1985 period, there was a trend towards increased use of se-
curities markets to finance corporate activity. This trend was accelerated by the
announcement of the European Single Act in 1985, which set the stage for a
more complete financial integration of the European Community. Walter & Smith
[1989] show that, at the end of 1987, the total volume of new security issues by
European corporations in the intra-European capital market had reached approx-
imately 70% of the comparable corporate financing activity in the U.S., and 78%
of the level of comparable activity in Japan (reproduced here in Table 5, panel A).
In part, this trend reflects the large privatization programs in France and the U.K.
in 1986 and 1987.
Interestingly, as shown in panel B of Table 5, while the Eurobond and Euro-
equity markets are the largest European securities markets, European nonfinan-
cial corporations sell most of their new issues in their respective domestic markets.
The largest players in the Eurobond and Euroequity markets are governments and
multinational corporations, particularly of Japanese origin.
Observation 5 Volume of European SPOs. By 1987, the dollar volume of new

security issues made by European nonfinancial corporations had reached approx-
imately three-quarters of the corresponding issue volume in the U.S. and Japan.
The 1987 total issue volume in European domestic markets was approximately
four times the combined volume in the Eurobond and Euroequity markets. Euro-
pean equity issues by nonfinancial institutions had grown to more than twice the
volume of equity issues in the U.S. and in Japan.
3. Flotation methods and costs
3.1. Frequency of major flotation methods
SPOs of common stock are sold through a wider array of alternative flotation
methods than is the case for IPOs. This reflects the fact that IPO stocks lack an
Table 5
Volume of equity and bond issues in the U.S., Europe and Japan ~
Panel A: Volume of domestic corporate security issues in 1987 ($ billion)
United States Europe Japan

Financial Non- Total Financial Non- Total Financial Non-
financial financial financial
Equities 25.3 28.1 53.4 13.8 75.8 c 89.6 14.0 28.5
Bonds a 143.2 220.1 363.3 170.1 31.5 201.6 227.9 b 103.1
Total e 168.5 248.2 416.7 183.9 107.3 291.2 241.9 131.6
Panel B: Security issues by European nonfinancial corporations, 1985-1987 ($ million) f
Nonfinancial debt issues Nonfinancial equity issues Total nonfinancial issues

Euro and Domestic Total Euro and Domestic Total Euro and Domestic To
foreign bonds bonds foreign equities foreign is
1985 11,779 1 2 , 2 4 9 24,028 2,660 23,610 26,270 1 4 , 4 3 9 35,859 5
1986 25,314 19,122 44,436 13,112 45,886 58,998 38,426 65,008 10
1987 13,576 23,894 37,470 9,873 64,113 73,986 23,449 88,007 11
1988 31,996 n.a. 6,351 n.a. 38,347 n.a.
a Source: Walter & Smith [1989]. Their original data sources include Securities Data Co. for
and foreign data, and OECD for domestic data. The footnotes below are from the original tal
b Includes discount notes issued by banks, many of which can be considered short term.
c Total gross shares sold through public distributions, including privatization issues.
d Includes private placements where reported, as well as local government and revenue bonds
e Issues by domestic firms outside their home regions are excluded, for example, U.S. corp,
issues of Eurobonds. However, the total includes European corporate sales of Euro-issues
foreign issues estimated at $ 35.7 billion in 1987.
f The volume of nonfinancial issues is 29.9%, 38.3%, 38.3% of the total issue volume in 1985,
1987, and 1988, respectively.
active s e c o n d a r y m a r k e t w h e r e c u r r e n t prices for the stock are easily o b t a i n

a n d h a v e a small n u m b e r of c u r r e n t s t o c k h o l d e r s . A l t e r n a t i v e m e t h o d s of ftoa
s e a s o n e d c o m m o n stock i n c l u d e firm c o m m i t m e n t offers w h i c h c a n b e ei
p r i v a t e l y n e g o t i a t e d or c o m p e t i t i v e l y b i d o r by shelf registration, b e s t eft
offers, rights offers, rights offers with s t a n d b y u n d e r w r i t i n g , direct issues q
to s e c u r i t y h o l d e r s of a c q u i r e d firms) a n d p r i v a t e p l a c e m e n t s . C o m m o n stoc
also s o m e t i m e s sold to the issuer's o w n s e n i o r s e c u r i t y h o l d e r s t h r o u g h exch~
offers a n d swaps. I n a d d i t i o n , stock is sold t h r o u g h t h e i s s u a n c e of convert
securities, w a r r a n t s a n d stock o p t i o n s a n d t h r o u g h the e s t a b l i s h m e n t of divid
r e i n v e s t m e n t , e m p l o y e e stock o w n e r s h i p a n d m a n a g e m e n t c o m p e n s a t i o n plan~
I n a rights offer, c u r r e n t s h a r e h o l d e r s a r e given s h o r t - t e r m w a r r a n t s o n a
r a t a basis, allowing s h a r e h o l d e r s t h e o p t i o n to e i t h e r p u r c h a s e t h e n e w share
sell t h e w a r r a n t s i n t h e m a r k e t b e f o r e e x p i r a t i o n (typically 20 days). U n s u b s c r i
s h a r e s a r e offered to s h a r e h o l d e r s w h o wish to p u r c h a s e m o r e t h a n t h e i r p r o
s h a r e o f t h e issue ( o v e r a l l o t m e n t o p t i o n o r g r e e n shoe). T h e rights s u b s c r i p
price is typically 15-20% below the current market price of the stock. In the U.S.,
Canada and Europe, corporate law typically dictates that the corporate charter
grant current shareholders the first right of refusal to purchase a new issue of
voting stock. Thus, the issuer must amend its charter, eliminating the preemptive
rights requirement, before a flotation method other than a rights issue can be
used. Such charter amendments were particularly popular among NYSE- and
AMEX-listed industrial firms in the late 1960s and the early 1970s [Bhagat, 1983].
Since current shareholders capture the full value of the rights by either sub-
scribing or selling the rights in the secondary market, it is often argued that
the issuer can costlessly increase the rights subscription price discount until the
offer is virtually guaranteed to succeed. However, as discussed later, this argu-
ment does not necessarily hold in a world of asymmetric information, which may
explain why rights issuers often hire an underwriter to guarantee the proceeds
on any unsubscribed shares. We refer to this flotation method as 'rights with
standby underwriting' or simply as 'standbys'. Rights offers in the U.S. are typically
fully subscribed [Eckbo & Masulis, 1992], and the typical underwriter takeup in
standbys is 15% of the issue [Singh, 1992].
If rights are not used, the firm can attempt to sell the issue directly to the market
with no financial intermediary, place the issue with a private group of investors (a
private placement), or employ an intermediary, usually an investment banker or
underwriting syndicate. There are several forms of investment banking contracts.
In a best efforts offer, the investment banker simply acts as a marketing agent for
the issuer, and the issuer bears the risk of offer failure. In contrast, in a firm com-
mitment underwriting agreement, the investment banker guarantees the proceeds
from the entire issue, bearing the responsibility for selling the shares to the public.
In the U.S., a firm formally starts the issuance process by filing a registration
statement with the SEC. In the case of a firm commitment offer, the issuing firm
and the investment banker then issue a preliminary prospectus in order to elicit
interest in the offer from potential investors. This prospectus states minimum and
maximum offer prices and the maximum number of shares to be sold (including
overallotments). Following S E C approval of the issue, the actual offer price and
number of shares to be sold are determined at a pricing meeting of the issuer
and the underwriter. Normally, the issue is offered to the public within 24 hours
of the pricing meeting. Common stock offers are typically made near the stock
market open but also occur in late afternoon after the close of exchange trading.
The underwriter's guarantee of the offer proceeds becomes effective only after
the offer price is set; up to this point the firm itself bears the proceeds risk.
In the case of a best efforts underwritten offer, the prospectus issued following
SEC approval contains a definite minimum sales level, and the issuer precommits
to withdrawing the entire issue if this minimum is not met during the specified
offer period. Because of the downward pressure that the offering places on the
secondary market price, syndicates typically execute price support activities in the
secondary market during the public offering.
Since the early eighties, the public offering process has been simplified by
the SEC which introduced an expedited registration procedure as well as the
so-called 'shelf registration' procedure for large well known firms. The expedited
registration procedure speeds up SEC approval of a specific issue, while the shelf
registration procedure allows the issuer to preregister potential equity offerings
where a number of alternative underwriters can be specified. Under the latter
procedure, the firm can sell part or all of the issue to an underwriter or syndicate
on a moment's notice any time over the two year life of the shelf registration filing.
The possibility for rapid sale of new equity has also been enhanced by the
emergence of the 'bought deal'. In a bought deal, a development caused by
competition among underwriters, an investment bank or securities firm quickly
purchases the entire stock issue for a minimum fee, with no further obligations on
the part of the issuer. This flotation method, which has been particularly popular
in Canada and in Euroequity markets in the 1980s, is seen as a way for relatively
unknown securities firms to compete for underwriting business in a market where
it is often difficult to break the existing relationship between the issuer and its
traditional choice of investment banker.
Table 6 shows the frequencies of common stock issues by the firm commitment,
standby and uninsured rights methods for NYSE and A M E X listed stocks since
1935. The time series trends of these three flotation methods are noteworthy.
As shown, from the mid 1930s through the mid 1950s, rights plus standby offers
tended to exceed firm commitment offers. However, over the 1960-1983 period
rights have declined in frequency, virtually disappearing by 1980. Standby offers
have shown a similar but less precipitous decline in recent years. The causes for
these declines are addressed later in this essay.
Table 7 shows that straight debt as well as securities which involve a contingent
equity sale, such as convertible bonds and convertible preferred stock, are also
typically issued by a firm commitment contract. 3 The information, which is based
on the SEC's Registered Offerings Statistics Tape for the 1977-1982 period as
compiled by Booth & Smith [1986], also indicates that more than 90% of the
c o m m o n stock firm commitment underwriting arrangements are 'negotiated' as
opposed to 'competitive', while 25% of the straight bond firm commitments are
competitive.
Observation 6 SPO flotation method trends in the U.S.

(i) Over the past 60 years, publicly traded U.S. companies have gradually
switched from the uninsured rights and standby flotation methods to the firm
commitment method. By 1980, the rights method has virtually disappeared i n
the group of large publicly traded industrial firms.
(ii) U.S. firms also show an overwhelming preference for the firm commit-
ment method when offering securities other than common stock, including
mortgage bonds, straight bonds, convertible debt, convertible preferred and
warrants.
3 Eckbo [1986] finds that in a large sample of corporate debt issues by publicly traded firms over
the period 1964-1981 less than 5% were sold using the rights offer method.
Table 6
Primary offers of seasoned common stock by NYSE and AMEX-listed firms, classified by the
flotation method (FC = firm commitments, Stand = standby rights), over the periods 1935-1955
and 1963-1981
Total issues Industrial issues Utility issues
Total FC Stand Right Total FC Stand Right Total FC Stand Right
Source: Stevenson [1957] a
1935 6 1 3 2 5 - 3 2 / 1 . . . .
1936 37 11 17 9 37 11 17 9 . . . .
1937 40 15 18 7 39 15 17 7 1 - t -
1938 5 2 - 3 4 1 - 3 1 1 - -
1939 13 6 3 4 8 5 3 - 2 1 - 1
1940 18 9 4 5 13 7 4 2 3 2 - 1
1941 9 1 3 5 9 5 3 1 6 2 - 4
1942 1 1 - 1 1 . . . . .
1943 14 8 5 1 13 7 5 1 1 1 -
1944 23 13 9 1 22 12 9 1 1 1 -
1945 52 23 18 II 45 20 15 10 7 3 3 1
1946 110 73 24 13 96 65 21 10 14 8 3 3
1947 53 27 12 14 29 19 5 5 24 8 7 9
1948 61 20 20 21 28 11 9 8 33 9 11 13
1949 79 27 30 22 14 7 5 2 65 20 25 20
1950 84 35 31 18 30 16 9 5 54 19 22 13
1951 131 61 49 21 63 40 16 7 68 21 33 14
1952 131 66 43 22 71 41 20 10 60 25 23 12
1953 120 55 47 18 43 28 11 4 77 27 36 14
1954 101 51 33 17 51 36 11 4 50 15 22 13
1955 113 44 56 13 56 29 25 2 57 15 31 11
Source: Eckbo and Masulis [1992] 6

1963 12 2 6 4 5 1 3 1 7 1 3 3
1964 17 8 6 3 8 4 3 1 9 4 3 2
1965 20 5 9 6 11 5 4 2 9 0 5 4
1966 27 12 12 3 17 7 8 2 10 5 4 1
1967 26 12 9 5 17 9 4 4 9 3 5 1
1968 44 26 9 9 31 20 4 7 13 6 5 2
1969 42 24 15 3 22 13 7 2 20 11 8 1
1970 49 36 10 3 22 18 2 2 27 18 8 1
1971 84 65 15 4 44 40 2 2 40 25 13 2
1972 81 68 11 2 29 27 1 1 52 41 10 1
1973 58 50 6 2 12 10 1 1 46 40 5 1
1974 53 47 4 3 6 5 0 1 47 42 3 2
1975 89 79 8 1 20 19 1 0 69 60 8 1
1976 93 88 3 1 30 29 1 0 63 59 3 1
1977 65 62 3 0 2 2 0 0 63 60 3 0
1978 90 86 3 1 25 23 2 0 65 63 1 1
1979 85 81 2 2 21 20 0 1 64 61 2 1
1980 162 157 2 3 87 86 0 1 75 71 2 2
1981 152 149 1 2 64 63 0 1 88 86 1 1
a Stevenson [1957] lists c o m m o n stock issues with proceeds over $1 million. Original data sources
include Sullivan and Cromwell Issuer Summaries 1933-1950, and The Commercial and Financial
Chronicle 1950-1955.
b Original data sources include the Wall Street Journal Index, the Investment Dealer's Digest,
and Moody's lndustrials and Utilities Manuals. The sample excludes simultaneous offers of
debt/preferred stock/warrants, combination primary/secondary stock offerings, cancelled or post-
poned offers, and non-U.S, issues.
1030 B.E. Eckbo, R.W.. Masulis
Table 7
Alternative methods of security issuance by type of security, U.S. 1977-1982 a
M e t h o d of Type of security
security issuance
Mortgage Straight Preferred Convertible Convertible Common
bonds bonds stock bonds preferred stock stock
Use of underwriters
Noninitial registered
offerings (NIR) b
firm c o m m i t m e n t c 454 896 221 240 70 1,008
best efforts 2 128 0 5 1 27
rights with standby 0 7 1 4 0 29
rights without standby 1 2 3 3 1 67
self-registered d 2 205 7 2 2 106
% firm c o m m i t m e n t 98.9 72.4 95.3 94.5 94.6 81.5
Initial registered offerings (IR)

firm c o m m i t m e n t c 29 68 1 14 4 396
best efforts 3 22 0 2 0 470
rights with standby 0 0 i 0 0 5
rights without standby 1 0 1 1 0 14
self-registered d 1 28 3 3 3 106
% firm c o m m i t m e n t 87.9 57.6 16.7 70.0 57.1 40.0
Types of firm commitment underwriting arrangements

Noninitial registered
offerings (NIR) b
Utilities
negotiated 201 58 122 5 7 413
competitive 199 12 61 0 0 43
% negotiated 50.2 82.9 67.7 100.0 100.0 90.6
O t h e r industries
negotiated 35 816 36 235 63 551
competitive 19 25 2 0 0 1
% negotiated 64.8 97.0 94.7 100.0 100.0 99.8
a Source: Booth & Smith [1986]. T h e footnotes below are from the original table. The table
s u m m a r i z e s data from the Registered Offering Statistics Tape provided by the Securities and
Exchange Commission. Data include all issues listed on the tapes where type of underwriting
a r r a n g e m e n t could be identified. Rule 415 security issues are excluded. T h e type of underwriting
a r r a n g e m e n t varies based on security type and whether the offering is an initial registration.
Firm c o m m i t m e n t is the most c o m m o n arrangement. A m o n g firm c o m m i t m e n t issues, choice of
competitive versus negotiated offering is related to the priority of the security claim. Competitive
underwriting is less c o m m o n despite its lower level of underwriter compensation.
b Includes initial offers of securities by firms already registered with the SEC.
c D a t a set includes all firm c o m m i t m e n t offerings that could be identified as being underwritten
either competitively or on a negotiated basis for the 1977-1982 period.
d Includes issues where no underwriter was utilized. Self-registration tends to occur between issuers
and investors with much in c o m m o n and where an active securities market is of little value. For
example, shares of cooperative ownership such as a grocery cooperative are often issued without
use of an investment banker.
In contrast, Table 7 confirms that IPOs are primarily sold through best effort and
firm commitment contracts, with approximately 40% of the IPOs sold using the
best efforts method. The popularity of best efforts and firm commitment contracts
for IPOs reflect several factors specific to this offer category: IPO stocks have no
secondary market price information prior to the issue, no stock analyst following,
little publicly available information about the firm, and high share ownership
concentration with management generally being a major holder. These factors all
contribute to a more severe informational asymmetry between existing sharehold-
ers and outside investors, increasing the uncertainty over the stock's true value.
Observation 7 IPOflotation methods. In the U.S., IPOs are sold almost exclusively
by means of the firm commitment method (approximately 60%) and the best
efforts underwritten method (approximately 40%).
As documented by Eckbo & Masulis [1992], concurrent with the disappearance

of rights and standby offers in the U.S., these same firms have increasingly relied
on new methods of raising equity capital from shareholders and employees such
as dividend reinvestment plans (DRIPs) and employee stock ownership plans
(ESOPs). In a DRIP, shareholders can elect to receive shares of common stock
in lieu of cash dividends. The shares sold through these plans can be purchased
in the secondary market by the firm or, if the D R I P is registered with the SEC,
the firm can issue new shares. When new shares are issued through DRIPs, it is
common to allow shareholders to purchase additional shares in excess of their
dividends up to some maximum dollar amount on the ex-dividend date [Scholes &
Wolfson, 1989]. Thus, given the well-documented inflexibility of dividend payouts,
D R I P s are in many ways similar to a periodic rights offer.
In an ESOP, employees are vested with shares of stock after fulfilling a specific
period of service in the firm. This represents an alternative to a higher wage or
retirement benefit. In addition, employees often can elect to purchase for cash
a specified number of additional shares at a discount from the current market
price. The periodic purchase or crediting of shares through the ESOP is similar to
a predictable sale of stock by the firm which raises new capital or reduces other
employee expenses. As such, it is similar to a D R I P even though the purchasers
are employees rather t h a n existing shareholders and the plan falls under more
restrictive tax and retirement regulations. 4
Observation 8 DRIPs and ESOPs. There is evidence that D R I P s and ESOPs,

which in many ways are similar to periodic rights offers, to some extent have re-
placed rights issues as a means of raising capital from shareholders and employees.
Several researchers have found that equity issuers in smaller capital markets,
which generally have a small equity capitalization, tend to rely on rights offers,
private placements and dividend reinvestment plans to sell common stock. For
4 See Chang [1990] for a further description.

1032 B.E. Eckbo, R. W.. Masulis
example, the current low frequency of rights issues in the U.S. contrasts sharply
with that in Canada where in recent years almost half of all equity issues are sold
through rights offers. Furthermore, in Europe, with the exception of issues in the
E u r o b o n d and the Euroequity markets, the majority of all issues are sold through
rights or standby offers, though recent trends toward greater firm commitment
and standby use have occurred in a number of these countries as well s This is also
the case in most Pacific Basin countries. For example, while approximately 80%
of SPOs on the Tokyo Stock Exchange were sold through rights in the 1950s, as
shown in Table 8, this percentage had decreased to approximately 20% by 1990,
with 80% of the SPOs currently issued through firm commitments.
Observation 9 International flotation method trends. Domestic issues in the Cana-

dian, the European and most Pacific Rim capital markets are predominantly sold
through rights. There is a trend towards increased use of underwriters and the
firm commitment method in the larger of these markets as well. In Japan, one of
the largest stock markets, a majority of equity issues is now sold through the firm
commitment method.
3.2. Direct flotation costs
Table 9 lists average direct flotation costs for uninsured rights, standbys and
firm commitment offers from a sample of 1249 SPOs compiled by Eckbo &
Masulis [1992]. In a rights offer, the direct costs of issuing equity are limited to
fees for legal- and accounting services, trustees' fees, listing fees, printing and
engraving expenses, SEC registration fees, Federal Revenue Stamps, and state
taxes. Firms issuing rights typically obtain subscription precommitments from
large shareholders for a significant portion of the issue (on average 60%), and the
rights are typically fully subscribed by the end of the subscription period. Thus,
any expected rights offer failure costs for these firms are small. 6 As shown in Table
9, the average direct costs of uninsured rights as a percent of total issue proceeds
is 1.8% for industrial issuers and 0.5% for utility issuers.
In a standby offer, the firm also pays a fee to the underwriter. The underwriter
compensation typically consists of two components: a fixed commitment fee and a
takeup fee on all rights exercised by the underwriter at the rights offer expiration.
The typical subscription or exercise rate in a standby offer exceeds 70%. Thus,
the risk to the standby underwriter from this commitment appears limited. The
average cost of standbys is 4.0% of gross proceeds for industrials and 2.4% for
utilities, respectively. In best efforts and firm commitment offers, the underwriter
receives a fixed fee (which, as noted above, typically is established through
5 For international evidence on equity issues, see Bchren, Eckbo & Michalsen [1992] (Norway),
Dehnert [1991] (Australia), Hietala & L6yttymemi [199l] (Finland), Kato & Schallheim [1991]
(Japan), Loderer & Zimmerman [1987] (Switzerland), MacCulloch [1990] (New Zealand), and
Marsh [1979] (the UK).
6 Firms issuing shares through DRIPs and ESOPs generally absorb commissions and other
expenses associated with the sale of stock.
Table 8
E q u i t y s e c u r i t y issues by firms listed o n the Tokyo Stock Exchange, 1956-1990 a
R i g h t s offerings P u b l i c offerings Private Exercise Total

placements of w a r r a n t s
No. of Amount No. of Amount No. of Amount No. of Amount No. of Amount
issues raised issues raised issues raised issues raised issues raised
( ¥ bils.) (¥bils.) (5(bils.) (5(bils.) (5(bils.)
1956 294 157 36 4 11 2 - - 341 164

1957 292 199 40 5 10 1 - - 342 205
1958 147 160 30 5 3 0 - - 180 165
1959 158 153 60 10 3 0 - - 211 183
1960 275 331 100 35 4 1 - - 379 387
1961 465 632 224 80 6 1 - - 695 712
1962 554 587 171 20 9 3 - - 734 609
1963 508 410 157 38 8 7 - - 673 453
1964 434 623 85 4 14 3 - - 533 631
1965 95 115 19 1 8 3 - - 122 117
1966 173 202 34 1 24 8 - - 231 212
1967 190 194 68 5 13 4 - - 261 202
1968 201 303 80 10 12 2 - - 293 315
1969 300 447 145 55 14 5 - - 469 506
1970 316 538 203 138 18 5 - - 537 681
1971 220 409 147 84 24 44 - - 391 637
1972 180 284 275 665 43 92 - - 498 1,041
1973 177 344 256 565 45 30 - - 478 939
1974 214 244 193 277 31 23 - - 438 544
1975 166 771 103 222 16 8 - - 285 1,001
1976 102 180 181 500 11 9 - - 294 689
1977 120 291 238 604 48 29 - - 406 923
1978 86 267 195 565 62 84 - - 313 897
1979 64 262 229 629 42 63 - - 325 953
1980 34 90 218 881 28 81 - - 280 1,052
1981 67 494 249 1,396 20 37 - - 336 1,928
1982 45 224 209 1,103 14 21 4 2 272 1,349
1983 18 135 72 472 23 165 18 30 131 802
1984 23 91 128 821 18 68 39 66 208 1,043
1985 40 183 103 506 18 33 70 137 231 859
1986 27 69 76 400 18 30 118 373 235 673
1987 26 436 99 1,394 22 109 241 1,074 388 3,013
1988 40 787 157 2,582 23 104 316 1,309 536 4,782
1989 32 726 227 5,830 22 102 436 2,190 718 8,849
1990 39 825 121 1,975 21 315 397 678 578 3,792
a Source: T h e Tokyo S t o c k E x c h a n g e Fact Book, m u l t i p l e years• T h e t a b l e i n c l u d e s foreign issues•
negotiations but sometimes by competitive bids). Average firm commitment costs

are 6.1% for industrials and 4.2% for utilities.
While not shown i n T a b l e 9, f l o t a t i o n costs as a percentage of the gross proceeds
are also found to be higher for common stock offers than convertible debt offers of
Table 9
Mean (median) underwriter compensation and other flotation expenses for the sample
of seasoned common stock offers by U.S. firms, classified by the type of firm and
method of offering, 1963-1981 a
Flotation costs Firm commitments Standby rights Uninsured rights

Ind Utl Ind Utl lnd Utl
Number of observations 351 639 42 89 26 23

Underwriter compensation 1.47 1.78 1.20 0.56 -
($ millions) (1.03) (1.32) (0.47) (0.34)
Other expenses 0.16 0.14 0.36 0.38 0.11 0.45
($ millions) (0.15) (0.12) (0.19) (0.29) (0.09) (0.19)
Total costs 1.72 1.92 1.59 0.94 0.11 0.45
($ millions) (1.28) (1.45) (0.68) (0.72) (0.09) (0.19)
Total costs/ 6.09 4.23 4.03 2.44 1.82 0.51
gross proceeds (%) (5.53) (3.82) (3.32) (2.07) (0.94) (0.22)
Total costs/ 1.05 0.49 0.93 0.22 0.80 0.05
market value common (%) (0.68) (0.41) (0.57) (0.18) (0.30) (0.02)
a Source: Eckbo & Masulis [1992]. 'Ind' denotes industrial issues, and 'Utl' denotes
public utility. Data sources are the SEC Registered Offerings Statistics data tape and
issue prospectuses. The cost of the offer price discount in firm commitment offers
is not included, nor is the value of any 'Green Shoe' options. In the standby rights
category, the underwriter's compensation is computed using the actual takeup fee based
on subscription information.
comparable size. In turn, convertible debt offers are found to have higher flotation
costs than nonconvertible debt offers, controlling for issue size. This suggests that
the debt-equity issuance decision can be influenced by the lower flotation costs
associated with debt issues. It is also consistent with the proposition that flotation
costs are positively related to the variability of the security's price (shown below).
Furthermore, examining firm commitment offers by public utilities, Bhagat &
Frost [1986] document that the total underwriter compensation is significantly
higher for negotiated contracts than in contracts where the terms have been de-
termined through competitive bidding by underwriters. Despite this fact, utilities
almost exclusively rely on negotiated contracts. Also, Bhagat, Marr & Thompson
[1985] report that total underwriter compensation has decreased with the shelf
registration procedure. Denis [1993], however, presents contradictory evidence
that shelf issues are not less costly, but appeared so due to selection biases and
the inclusion of zero underwriting fee 'bought deals' in the shelf sample. Denis
[1991.] also finds more negative announcement effects for shelf issues, which is
consistent with a greater adverse selection effect due to the less complete 'due
diligence' investigation that occurs in the shelf process. Denis [1991] also observes
that the shelf registration procedure has not gained widespread popularity among
equity issuers.
Ch. 31. Seasoned Equity Offerings':A Survey 1035
In sum,
Observation 10 SPO flotation costs. The empirical evidence indicates that direct
flotation costs on average
(i) are higher for c o m m o n stock offers than for debt offers of comparable size,
and higher for convertible debt than for nonconvertible debt;
(ii) are higher for industrial issuers than for public utilities;
(iii) are lowest for uninsured rights and highest for firm commitments, with
standbys in between; and
(iv) are higher for negotiated than for competitive underwritten contracts.
Several studies have identified issue characteristics which are correlated with
direct flotation costs. Examples of such studies are Smith [1977], H a n s e n &
Pinkerton [1982], Smith & Dhatt [1984], Bhagat, Marr & T h o m p s o n [1985],
Bhagat & Frost [1986], B o o t h & Smith [1986], Ritter [1987], H a n s e n [1989],
H a n s e n & Torregrosa [1992], Eckbo & Masulis [1992], and B0hren, Eckbo &
Michalsen [1992]. Table 10 shows the coefficient estimates in cross-sectional
regressions on such characteristics (Table 10A for industrial issuers and Table 10B
for utility issuers). T h e regressions, which are highly significant, are based on the
sample of SPOs in Eckbo & Masulis [1992]. T h e dependent variable is direct
flotation cost as a percent of offer proceeds, while the explanatory variables
include offer size, percentage change in shares outstanding, issuer's regulatory
status, stock systematic and unsystematic risk, shareholder concentration, and
binary variables for the flotation method.
T h e regression intercept is positive and significant indicating a fixed c o m p o n e n t
to flotation expenses. Furthermore, the significance of the natural log of the
issue's gross proceeds (PRO), and PRO 2 indicate that the flotation cost function is
decreasing and convex in the gross proceeds of the offer (i.e., economies of scale).
T h e log of equity capitalization per shareholder (SCON) is significantly negative,
indicating that shareholder concentration lowers flotation costs. 7 The standard
deviation of the issuer's daily stock return (ST) is positive and statistically signif-
icant for firm c o m m i t m e n t issues, probably because greater stock risk increases
underwriting risk and therefore the underwriter fee. This effect is to a smaller
degree reflected in the standby rights issues. In the pure rights category, ST is
7 Firms with concentrated ownership tend to obtain subscription precommitments which lowers
flotation costs. However, Eckbo & Masulis [1992] find that the statistical impact of the ownership
concentration variable is not fully explained by the presence of subscription precommitments.
Hansen & Pinkerton [1982] use a nonlinear flotation cost function that includes ownership
concentration to estimate the hypothetical flotation cost of a rights offer for a sample of firms
that choose the firm commitment method, and conclude that rights offers would have entailed
higher costs. However, their t-statistics are conditional on the functional form used to generate the
flotation cost structure and are therefore difficult to assess. Also, Smith & Dhatt [1984] argue that
the Hansen-Pinkerton shareholder concentration parameter is biased, and that correction for this
bias leaves rights offers as the cheapest flotation method.
1036 B.E. E c k b o , R.W. M a s u l i s
Table 10A
OLS parameter estimates in cross-sectional regressions of percentage flotation costs against issue
characteristics and offering method, for industrial issuers in the U.S., 1963-1981 a (t-statistics in
parentheses)
Const. PRO PRO 2 SCON ST A SHR D1 D2 R2 F value

Oto Otl ~2 °t3 Or4 °t5 °16 °t7
L Firm commitments (N = 334)

(1) 0.588 -0.093 0.004 -0.003 0.504 0.024 - - 0.73 179.5
(11.09) (-8.74) (7.41) (-3.44) (5.87) (3.49)
(2) 0.584 -0.091 0.004 0.004 0.573 - - - 0.72 214.1
(10.83) (-8.42) (7.12) (-5.00) (6.74)
II. Standby rights (N = 41)
(3) 0.427 -0.070 0.003 -0.005 0.368 0.00"- - - 0.75 25.2
(6.60) (-5.28) (4.63) (-2.03) (1.53) (0.23)
(4) 0.427 -0.070 0.003 -0.005 0.393 - - - 0.75 32.3
(6.68) (-5.35) (4.69) (-2.11) (1.85)
IlL Pure rights (N = 26)
(5) 0.351 -0.069 0.003 -0.003 0.421 -0.007 - - 0.84 28.9
(6.39) (-5.56) (4.88) (-1.50) (2.64) (-0.92)
(6) 0.340 -0.067 0.003 -0.002 0.371 - - - 0.84 36.2
(6.36) (-5.51) (4.82) (-1.19) (2.48)
IV. All three flotation methods (N = 403)
(7) 0.336 -0.057 0.002 -0.003 0.451 0.010 0.026 0.044 0.76 181.5
(9.43) (-7.93) (6.20) (-4.32) (5.56) (1.95) (12.16) (14.08)
(8) 0.339 -0.057 0.002 -0.004 0.496 - 0.026 0.043 0.76 209.7
(9.47) (-7.88) (6.17) (-5.33) (6.35) (12.03) (13.9)
a The data underlying these regressions are from Eckbo & Masulis [1992]. The flotation cost in firm
commitment offerings includes underpricing relative to the market price on the day prior to the
offering day.
Variable definitions:
PRO = natural log of gross proceeds of offering,
P R O 2 = square (PRO),
S C O N = natural log of share value at the offering divided by number of shareholders (based on
offering price),
ST = standard deviation of issuer's daily stock return over 450 trading days starting 60 days
prior to the Wall Street Journal offering announcement,
2x S H R = percentage change in shares outstanding due to the offering (new shares divided by old
plus new shares),
D1 = indicator variable of offering method (standby or firm commitment offering = 1),
D2 = 2nd indicator variable of offering method (firm commitment offering = 1),
significant for industrial issuers but not for utilities. 8 Finally, the percent change
i n s h a r e s ( A S H R ) is s t a t i s t i c a l l y s i g n i f i c a n t o n l y f o r t h e s a m p l e o f i n d u s t r i a l f i r m
commitments, where it r e c e i v e s a p o s i t i v e c o e f f i c i e n t . A s d i s c u s s e d l a t e r i n t h i s
8 Since a rights offer requires a minimum 14-day subscription period, it is possible that S T
represents a proxy for the risk of offer failure due to random changes in stock price over the
Table 10B
OLS parameter estimates in cross-sectional regressions of percentage flotation costs against issue
characteristics and offering method, for utility issuers in the U.S., 1963-1981 ~ (t-statistics in
parentheses)
m
Const. PRO PRO 2 SCON ST ASHR DI D2 R2 F value

~0 ~1 if2 if3 c~4 c~5 ~6 ~7
L Firm commitments (N = 629)

(1) 0.500 -0.083 0.004 -0.006 1.717 0.0001 - - 0.34 65.3
(9.19) (-7.98) (7.39) (-5.43) (9.82) (0.009)
(2) 0.500 -0.083 0.004 -0.006 1.719 - - - 0.34 81.7
(9.20) (-7.99) (7.40) (-5.89) (9.83)
lI. Standby rights (N = 85)
(3) 0.470 -0.080 0.004 -0.008 0.683 0.010 - - 0.57 23.9
(6.62) (-5.72) (5.20) (-3.85) (2.00) (0.28)
(4) 0.474 -0.081 0.004 -0.008 0.679 - - - 0.58 30.3
(6.83) (-5.86) (5.35) (-3.93) (2.00)
1H. Pure rights (N = 22)
(5) 0.156 -0.024 0.001 -0.003 0.198 0.001 - - 0.73 13.0
(3.67) (-3.02) (2.77) (-2.14) (0.90) (0.03)
(6) 0.155 -0.024 0.001 -0.003 0.198 - - 0.75 17.2
(3.86) (-3.19) (2.93) (-2.21) (0.93)
IV. All three flotation methods (N = 738)
(7) 0.433 -0.078 0.003 -0.005 1.573 0.003 0.023 0.013 0.48 99.5
(10.10) (-9.29) (8.59) (-6.08) (10.05) (0.29) (13.04) (3.53)
(8) 0.433 -0.078 0.003 -0.006 11574 0.023 0.013 0.48 116.2
(10.12) (-9.30) (8.60) (-6.60) (10.07) (13.22) (3.52)
a See Table 10A for variable definitions.
survey, it is p o s s i b l e t h a t larger p e r c e n t a g e c h a n g e s in s h a r e s s u b j e c t s h a r e h o l d e r s
to g r e a t e r costs o f a d v e r s e selection, raising t h e u n d e r w r i t e r fee for the m o r e risky
i n d u s t r i a l firm c o m m i t m e n t issues.
T h e i n d i c a t o r v a r i a b l e s D1 a n d D2 in the p o o l e d r e g r e s s i o n s a d j u s t for the flota-
t i o n m e t h o d a n d s u p p o r t the e a r l i e r e v i d e n c e f r o m Table 9 that rights offers have
t h e lowest direct f l o t a t i o n costs. D1 s e p a r a t e s u n d e r w r i t t e n offers ( s t a n d b y s a n d
firm c o m m i t m e n t s ) f r o m n o n u n d e r w r i t t e n offers ( u n i n s u r e d rights), while D2 sep-
a r a t e s firm c o m m i t m e n t s f r o m all rights offers. T h e positive a n d statistically signif-
i c a n t i m p a c t of b o t h D1 a n d D2 for i n d u s t r i a l issuers suggests t h a t t h e choice of a n
u n d e r w r i t t e n offer ( s t a n d b y or firm c o m m i t m e n t ) i n c r e a s e s t h e f l o t a t i o n costs, a n d
t h a t the choice of a firm c o m m i t m e n t offer i n c r e a s e s t h e s e costs further. F o r utili-
ties, t h e D1 p a r a m e t e r is significant a n d positive i n d i c a t i n g a g a i n t h a t u n d e r w r i t t e n
offers are m o r e costly. H o w e v e r , the D2 p a r a m e t e r is insignificant, i n d i c a t i n g that
rights subscription period (where failure involves higher costs of alternative sources of capital). The
greater the expected failure costs, the greater the issuer's distributional/selling effort which in turn
translates into higher 'other' expenses in the sample of industrial rights issues.
firm commitment and standby fees in utility offers are close in magnitude after
controlling for the other explanatory variables in the regression model.
Note that the coefficient estimates in Table 10 are remarkably similar across
flotation methods and across issuer types. Furthermore, while not shown in the
table, the coefficient estimates do not change much if one reestimates the model
excluding post-1975 offers (as shown in Table 6, 90% of the rights offers took place
before 1976). Thus, the results in Table 10 strongly indicate that the respective
issue characteristics represent fundamental determinants of direct flotation costs. 9
Observation 11 Flotation costs and offer characteristics. The empirical evidence

indicates that direct flotation costs depend on issuer characteristics such as gross
proceeds (scale economies), stock risk (value of underwriter guarantee), and
shareholder concentration (rights distribution costs). Direct flotation costs remain
lowest for uninsured rights and highest for firm commitments after controlling for
these issue characteristics.
It has become common for an issuer to grant the underwriter an overallotment

option which allows the underwriter to purchase additional shares at the offer
price to the extent that the issue is oversubscribed, up to a maximum of 15% of
the offer size. The value to the issuer of granting this option lies in its positive
effect on the underwriter's selling effort in the period prior to the public offer
date. Aggressive selling reduces the risk of offer failure but increases the risk of
oversubscription. Thus, the cost to the underwriter of unmet oversubscription (in
terms of disappointed clients) is reduced by allowing additional shares to be issued
ex post. Overallotment options are very common in firm commitment IPOs and
less frequent in firm commitment SPOs. Hansen, Fuller & Janjigian [1987] report
that the value of the overallotment options represents a very small fraction of a
typical seasoned stock issue's gross proceeds.
In a rights issue, and in shares offered through DRIPs, the subscription price
discount acts as a stock dividend paid to current shareholders. This discount
is defined as the difference between the offer price and the closing secondary
market price the day before or after the offer, divided by that same secondary
market price. In the U.S., this discount is typically 15-20% for rights, and 3 - 5 %
for new share DRIPS. The offer price discount represents a wealth transfer to
the purchasers and if these are outside investors, this represents as an additional
flotation cost component. The discount in underwritten IPOs is substantial, on
average 15-20% and largest in best efforts offers [Ibbotson, 1975; Ritter, 1984,
1987]. In contrast, there is very little evidence of underpricing in underwritten
SPOs when compared to the prior trading day's opening, closing, high or low
prices [Loderer, Sheenan & Kadlec, 1991; Eckbo & Masulis, 1992].
9 For evidence on the determinants of rights offer flotation costs in the U.K. and in Norway, see
Marsh [1980] and BChren, Eckbo & Michalsen [1992]. Also, see Hansen & Torregrosa [1992] who
examine underwriter spread determinants for common stock offers and find a negative relation to
firm size, the log of offering size, managerial stock ownership and institutional ownership and a
positive relation to residual stock risk and offer size.
Ch. 31. Seasoned Equity Offerings': A Survey 1039
When adding direct flotation e:~penses, underwriter fees and underpricing costs,
it is clear that the average IPO is more expensive than the average SPO. Total
flotation costs in the U.S. as a percent of offering proceeds in IPOs average
21% for firm commitments and 32% for best efforts [Ritter, 1987], compared to
the average 6% cost for industrial issuers shown in Table 9. In both IPOs and
SPOs, there are significant scale economies. 1° But IPOs have a much smaller
average size, which is one explanation why the average SPO has lower percent
flotation costs. Another reason is a SPO has lower price uncertainty due to the
existence of an active secondary market prior to the offering which implies lower
risk of offer failure. For IPOs, the offer failure rate is quite high [Ritter, 1987],
while cancellations or postponements of SPOs occur only rarely [Mikkelson &
Partch, 1988]. Offer failure causes issuers additional costs of obtaining funds from
alternative sources, or of abandoning promising investment projects.
Observation 12 Issue underpricing and overallotment options. Underpricing, while

large in IPOs, is negligible in firm commitment SPOs. Overallotment options,
which are common in firm commitment IPOs, are much less frequent in SPOs,
and the average value of this option is a very small percent of the SPO's gross
proceeds. Overall, flotation costs as a percent of offering proceeds, and the risk of
offer failure, are substantially higher for IPOs than for SPOs.
3.3. Additional costs of rights
As highlighted by Smith [1977], Hansen [1989], and Table 9-10 above, the
preference by U.S. managers for the relatively expensive firm commitment flota-
tion method over rights offers is puzzling. In particular, since the value of the
right increases with the subscription price discount, the rights issuer can virtually
guarantee success of the offer by properly adjusting the subscription price. So why
not select the cheaper rights method?
Smith [1977] suggests that the overwhelming preference for firm commitment
SPOs may reflect an agency problem. For example, managers may receive personal
benefits from underwriters who are selected to handle the equity issue. Second,
there may be pressure from the boardroom; H e r m a n [1981] finds that 21% of the
200 largest nonfinancials and 27% of the 100 largest industrial companies have
one or more investment bankers on their board of directors. The resulting conflict
of interest may lead to an excessive use of the underwritten flotation methods.
Third, while a rights offer is unlikely to substantially change the distribution of
voting rights, a sale to the public through an underwriter can increase shareholder
dispersion and therefore reduce shareholder monitoring of managers, thereby
enhancing potential manager welfare.
10Evidence of scale economies is shown in Table 10, above. SEC staff reports, Smith [1977], and
Smith & Dhatt [1984] also find that flotation costs as a percent of the gross proceeds for the typical
offer falls significantly as the dollar value of the offerings rises, but at a decreasing rate.
An alternative explanation for the apparent demise of the rights offer is that
other important shareholder borne costs of the rights offer method have been
ignored or underestimated, which value-maximizing managers have taken into
account. Examples of such costs are given below, and include capital gains taxes,
transaction costs of selling rights in the secondary market, wealth transfers due
to anti-dilution clauses which are a standard feature in convertible securities and
warrants, and costs due to asymmetric information.
(i) Capital gains taxes: In a rights offer, shareholders who do not wish to
purchase shares of the issue must sell their rights (or subscribe and sell the shares)
in order to avoid losing the value of the subscription price discount. These sales
are subject to capital gains taxes, which are increasing in the subscription price
discount, discouraging large discounts.
(ii) Stock liquidity and transaction costs of reselling rights: The resale of rights
by current shareholders takes place on organized exchanges, entailing dealer
spreads and brokerage fees. Since shareholders avoid these costs when the firm
employs an underwriter to sell its new shares, a rights offer carries a transaction
cost disadvantage for shareholders uninterested in subscribing to the issue. This
relative cost disadvantage is exacerbated if the efforts of the investment bankers
tend to increase stock liquidity and reduce bid-ask spreads when underwritten
methods are used.
(iii) Arbitrage activity and the risk of rights offer failure: Investors can use rights
as warrants to hedge their short sale positions in a firm's stock. This encourages
increased short selling of the stock, but as additional short positions are opened,
the stock price will tend to be depressed as resulting sell orders rise (at least
within the bid-ask spread). Thus, between the announcement of rights offer terms
and offer expiration, this short-selling activity tends to keep the stock price down,
reducing the attractiveness of exercising rights for most stockholders. This creates
additional uncertainty for issuers as to the ultimate rights offer subscription level,
which can cause the issuer to extend the expiration of the rights offer, increasing
flotation costs and creating continued downward pressure on stock price for the
extended life of a rights offer.
(iv) Anti-dilution clauses and wealth transfers to convertible security holders:
If a firm has convertible securities or warrants outstanding with anti-dilution
clauses in place, then issuing rights at discounts can trigger automatic reductions
in conversion rates of these securities as discussed in Kaplan [1965] and Myhal
[1990]. These anti-dilution clauses are likely to result in improved positions for the
convertible security holders, shifting wealth away from the common stock holders
who are the residual claimants. As a result, there is an added incentive for firms
with convertible securities outstanding to avoid issuing rights at deep discounts.
Observation 13 Additional costs of rights. Additional shareholder-borne costs

which tend to reduce the attractiveness of rights arise from capital gains taxes,
reduced stock liquidity, transaction costs of selling rights, arbitrage activity which
affects the risk of offer failure, and anti-dilution clauses which induce wealth
transfers to convertible security holders.
There is currently insufficient empirical evidence to dismiss these additional

costs of rights offers as immaterial, or to argue that any single one is the primary
reason for the demise of the rights issue. Smith [1977] estimates that the capital
gains tax disadvantage of rights, in a worst-case scenario, is at most 2% of offering
proceeds in the U.S., but this was before the capital gains tax rate was raised.
H a n s e n [1989] presents some evidence of selling pressure in the secondary market
for rights. 11 Kothare [1993] documents a negative effect of rights offers on stock
liquidity and b i d - a s k spreads over the rights period, while Lease, Masulis & Page
[1992] find b i d - a s k spreads to fall subsequent to firm commitments. Third, Eckbo
& Masulis [1992] find some evidence that the total n u m b e r of convertible security
issues has risen over the period when firms have switched f r o m rights to firm
c o m m i t m e n t offers.
As reviewed in Section 4 below, the literature on the valuation effects of
seasoned equity a n n o u n c e m e n t s strongly suggests the presence of important
information asymmetries in the primary market for c o m m o n stock. Perhaps
the most promising approach to resolve the rights offer puzzle is to explicitly
recognize the role of information asymmetries on the flotation m e t h o d choice.
R e c e n t attempts to capture this role are reviewed in Section 5.
4. Valuation effects of SPO announcements
4.1. Summary of evidence
A large n u m b e r of studies provide estimates of the valuation effects of security

issue a n n o u n c e m e n t s by exchange listed firms. Table 11 summarizes the main
findings of the literature on SPOs in the U.S., classified by type of security issued
( c o m m o n stock, straight/convertible preferred stock/bonds), by flotation m e t h o d
(uninsured rights offers, standby rights, firm commitments), and by issuer type
(industrial firm, public utility). Table 12 summarizes the evidence on other types
of c o m m o n stock and convertible security issue a n n o u n c e m e n t s by U.S. firms
(private placements, repurchase/exchange offers, conversion-forcing calls, D R I P s /
ESOPs, and offer cancellations/withdrawals), as well as on a n n o u n c e m e n t effects
of c o m m o n stock SPOs in other countries. 12
T h e well known negative price impact of firm c o m m i t m e n t SPO announcements
in the U.S. (on average - 3 % industrial issuers over the two-day a n n o u n c e m e n t
interval) has fascinated financial economists since its was d o c u m e n t e d in studies
11 Also, see Table 4 of Marsh [1979] for some U.K. evidence.

12A thorough discussion of the econometrics of event studies is provided by Rex Thompson in
another chapter of this volume. In the following, statistical inferences are made on the basis of
average announcement-induced abnormal returns and of parameters estimated in cross-sectional
regressions with announcement returns as dependent variable. While potentially important, we make
no attempt to adjust the conclusions of the various studies reviewed for the impact on announcement
returns of partial anticipation of the event [e.g., Malatesta & Thompson, 1985] or of selection bias
due to managerial private information [Eckbo, Maksimovic & Williams, 1990].
Table 11
Average two-day abnormal common stock returns and average sample size (in paren-
thesis) from studies of announcements of SPOs by NYSE/AMEX listed U.S. companies.
Returns are weighted averages by sample size of the returns reported by the respective
studies (all returns not marked with a '*' are significantly different from zero at the 5%
level).
Type of security offered Flotation method Type of issuer

Industrial Utility
Common stock Firm commitment -3.1 a -0.8 b

(216) (424)
Standby rights -l.5 c -1.40
(32) (84)
Rights - 1.4 e 0.2 e
(26) (27)
Preferred stock Firm commitment -0.78* f 0.1" g
(14) (249)
Convertible preferred stock Firm commitment -lAg -1.4g
(53) (8)
Convertible bonds Firm commitment -2.0 h n.a. i
(104)
Rights - 1.1 J n.a. i
(26)
Straight bonds Firm commitment -0.3* k --0.13" l
(210) (140)
Rights 0.4* 1 n.a.
(11)
a Asquith & Mullins [1986] (1963-1981, N = 128, -3.0); Masulis & Korwar [1986]
(1963-1980, N=388, -3.3); Mikkelson & Partch [1986] (1972-1982, N = 80, -3.6);
Bhaghat & Hess [1986] (1963-1978, N = 95, -4.3); Eckbo & Masulis [1992] (1963-1981,
U = 389, -3.3).
b Asquith & Mullins [1986] (N = 264, -0.9); Masulis & Korwar [1986] (N = 584, -0.7);
Bhaghat & Frost [1986] (N = 201, -1.0); Eckbo & Masulis [1992] (N = 646, -0.8).
c Hansen [1989] (1963-1985, N = 22, -2.6); Eckbo & Masulis [1992] (N = 41, -1.0).
d Hansen [1989] (N = 80, -2.3); Eckbo & Masulis [1992] (N = 87, -0.5).
e Eckbo & Masulis [1992].
f Linn & Pinegar [1988] (1962-1984, N = 14, -1.295"); Mikkelson & Partch [1986]
(N = 14, -0.26*).
g Linn & Pinegar [1988].
h Dann & Mikkelson [1984] (1970-1979, N - 132, -2.3); Eckbo [1986] (1964-1981,
N = 53, -1.9); Mikkelson & Partch [1986] (N = 33, -2.0); Jangigian [1987] (1968-1983,
N = 234, -1.7); Hansen & Crutchley [1990] (1975-1982, N = 67, -1.5).
i Not available (virtually none are issued by utilities).
i Dann & Mikkelson [1984] (N = 38, -1.2); Eckbo [1986] (N = 14, -0.8*).
k Dann & Mikkelson [1984] (N = 150, -0.37*); Eckbo [1986] (N = 310, -0.1");
Mikkelson & Partch [1986] (N = 171, -0.23*).
I Eckbo [1986].
Table 12
Average two-day announcement period abnormal stock return associated with equity issues or
retirements by means of nonstandard flotation methods, combination primary-secondary offerings,
swaps, exchange and repurchase offers, conversion-forcing debt calls, cancellations and withdrawals,
and international stock offerings. (All returns not marked with a '*' are statistically significant at the
5% level)
Study Flotation method/ Sample Two-day

type of offer size mean
ann. ret.
(%)
1. Primary issues of seasoned common stock, nonstandard flotation methods
Bhagat, Marr
& Thompson [1985] Shelf registration 83 -1.2
Biackwell, Marr
& Spivey [1990] Shelf registration
Denis [1991] Shelf registration 343 -2.6
Wruck [1989] Private placement 99 1.9*
Schipper & Smith [1986] Equity carve-out 76 0.7*
Dubofsky & Bierman [1988] Dividend reinvestment plan 53 0.8
Chang [1990] Employee stock ownership plan 165 3.7*
ll. Combination primary-secondary offerings of common stock
Masulis & Korwar [1986] firm commitment, no management sales 186 -2.2*
Korajczyk, Lucas
& McDonald [1990] firm commitment, with management sales 56 4.6*
III. Swaps, exchange offers, and repurchases of common stock
Masulis [1980a] Exchange, common stock for debt 20 -9.9*
Masulis [1980a] Exchange, common for preferred 30 -2.6*
Masulis [1980a] Exchange, preferred for common 9 8.3*
Masulis [1980a] Exchange, debt for common 52 14.0"
Lease & Pinegar [1986] Exchange, common for preferred 30 -1.5"
Lease & Pinegar [1986] Exchange, preferred for common 15 8.1"
Finnerty [1985] Private swap, common for debt 113 -1.1"
Rogers & Owers [1985] Private swap, common for debt 74 -1.l*
Israel, Ofer & Siegel [1989] Swap, common stock for debt 125 -1.6
Lease & Pinegar [1986] Exchange, preferred for common 15 8.1"
Masulis [1980b] Tend. off. repurchase of common 199 16.4"
Masulis [1980b] Debt. off. repurchase of common 45 21.9"
Dann [1981] Tend. off. repurchase of common 142 15.4"
Vermaelen [1981] Tcnd. off. repurchase of common 131 14.1"
Vermaelen [1981] Open mkt. repurchases of common 243 3.4*
IV Convertible debt and preferred stock calls
Mikkelson [1981] Calls forcing conversion of convertible debt 113 -2.1"
Mikkelson [1981] Calls forcing conversion of
convertible preferred stock 57 0.4
Campbell, Ederington
& VanKudre [1991] Calls forcing conversion of bonds 167 -1.5
Singh, Cowan & Nayar [1991] Call of convertible bonds (underwritten) 65 -2.0
Singh, Cowan & Nayar [1991],
Janjigian [1987] Call of convertible bonds (not underwritten) 64 -0.8
Table 12 (cont'd)
Study Flotation method/ Sample Two-day

type of offer size mean
ann. ret.
(%)
V. Cancellations and withdrawals of stock offers
Officer & Smith [1986] Withdrawals of nonconvertible debt 30 0.4
Officer & Smith [1986] Withdrawal of common stock offering 31 2.4
Mikkelson & Partch [1988] Withdrawnequity offering 62 1.3
VI. Common stock issues, international evidence
Marsh [1979] U.K.; rights and standbys 997 2.1
(month)
Hietala & Loyttyniemi [1991] Finland;rights and standbys 63 4.9*
Kang [1990] Korea; rights and standbys 89 1.5
Loderer & Zimmerman [1987] Switzerland;rights and standbys 99 2.0
(month)
Eckbo & Verma [1992] Canada; all SPO methods 69 -4.0*
BChren, Eckbo
& Michalsen [1992] Norway; rights and standbys 206 0.80*
Dehnert [199l] Australia, rights and standbys 158 -2.0*
by Asquith & Mullins [1986] and Masulis & Korwar [1986]. This fascination has
been increased by the findings that there are no significant negative price impacts
from announcements of (1) straight debt issues as reported by Eckbo [1986], (2)
equity issues sold through rights offers as reported by Eckbo & Masulis [1992],
and (3) private placements as reported by Wruck [1989].
The negative firm commitment evidence is further confirmed in Barclay &
Litzenberger [1988] who study transaction data and pinpoint the minute that a
c o m m o n stock offer announcement crosses the Broad tape (but only examine
equity offers over a short sample period). Also, as shown in Table 12, Officer
& Smith [1986] and Mikkelson & Partch [1988] report that common stock offer
c a n c e l l a t i o n s are associated with a significantly positive average a n n o u n c e m e n t
effect of slightly smaller magnitude than the average negative effect associated
with stock offer announcements.
C o m m o n stock can also be issued indirectly through a number of alternative
financing mechanisms such as the issuance of convertible securities which can
be viewed as a delayed stock offer. As seen from Table 11, the evidence from
these event studies is that public offers of convertible debt are associated with
significant negative announcement effects of a magnitude (on average - 2 % ) close
to that found for firm commitment stock offers, though the offering size tends
to be much larger. As shown in Table 12, a similar result is obtained when es-
timating the market reaction to debt calls which force conversion into common
stock [Mikkelson, 1981; Campbell, Ederington & Vankudre, 1991; Singh, Cowan
& Nayar, 1991]. The conjecture that the market interprets a convertible security
offer as equivalent to a stock offer might be questioned given that a number

of studies conclude that managers do not call convertibles as soon as they can
force conversion. However, Asquith [1992] finds that once the call protection
clauses in these issues are taken into account, the evidence clearly favours the
conclusion that managers do force conversion to common stock as soon as it is
feasible.
Table 11 also reveals a systematic relationship between the two-day announce-
ment effect and the choice of flotation method by industrial issuers. Firm com-
mitment issue announcements command the largest negative market reaction and,
while not shown in Table 11, the market reaction is more negative the larger
the issue size. Standby rights issues result in a significantly negative effect which
is approximately half of the firm commitment effect, while rights issues have an
insignificant announcement effect. As shown in Table 12, nonnegative announce-
ment effects are also reported by Dubofsky & Bierman [1988] and Chang [1990]
for the adoption of DRIPs and ESOPs which, as noted earlier, in many ways are
similar to periodic rights offers of stock.
The lack of a significant negative market reaction to the typical rights issue
also characterizes much of the international evidence on seasoned equity offerings,
as seen in Table 12, where rights/standby offers represent the primary flotation
method. Studies of offer announcement effects by Marsh [1979] for standby rights
issues in the UK, Loderer & Zimmerman [1987] for rights in Switzerland, Kang
[1990] for rights and standbys in Korea, Hietala & L6yttyniemi [1991] for rights
and standbys in Finland, and Bohren, Eckbo & Michalsen [1992] for rights and
standbys in Norway support this conclusionl Kato & Schallheim [1991] document
insignificant two-day announcement effects for firm commitment offerings in
Japan, while Dehnert [1991] and Eckbo & Verma [1992] find small negative
announcement effects of rights and standby offers in Australia and Canada,
respectively.
As shown in Table 12, studies of security exchange offers and swaps show
that leverage-increasing transactions (debt in place of equity) on average produce
significantly positive announcement returns, while leverage-decreasing transac-
tions (equity in place of debt) cause significantly negative effects [Masulis, 1980a,
1983; McConnell & Schlarbaum, 1981]. Moreover, transactions with no change in
leverage (debt for debt exchanges) produce insignificant announcement returns
[Eckbo, 1986; Mikkelson & Partch, 1986].
Overall, from the evidence summarized in Tables 11 and 12, it appears that the
market reaction to public offers is significantly different from zero only when the
financing decision either increases or reduces the (potential) amount of outstand-
ing common stock. Furthermore, the market reaction is negative when stock is
increased and positive when stock is decreased. Thus, debt/preferred stock issues
cause an insignificant market reaction unless exchanged for outstanding common
stock, in which case the reaction is significantly positive. Stock issues cause a
negative market reaction whether issued for cash or in exchange for more senior
securities.
The above results for SPOs can be summarized as follows:
Observation 14 Valuation effects" of SPO announcements in the US. For NYSE/

A M E X listed firms, the average valuation effect (typically represented by the
two-day announcement period abnormal stock returns) is
(i) nonpositive;
(ii) more negative the larger the size of the issue;
(iii) most negative tbr firm commitment offers, least negative (or zero) for
uninsured rights, with standby rights in between;
(iv) most negative for common stock, least negative (zero) for straight debt/
preferred stock, with convertible securities in between; and
(v) smaller for public utilities than for industrial issuers.
Furthermore,
Observation 15 Valuation effects of SPO announcements internationally. Interna-

tionally, where common stock is primarily issued using rights and standbys, the aver-
age market reaction is typically positive for uninsured rights and small but negative
for standbys (Australia, Canada, Finland, Japan, Korea, Norway, Switzerland, UK).
Furthermore, the evidence on announcement effects of other (non-SPO) capital

structure change announcements involving common stock is as follows:
Observation 16 Valuation effects of other capital structure change announcements.

For exchange listed U.S. firms, the average valuation effect (typically represented
by the two-day announcement period abnormal stock return) is
(i) positive for private placements of common stock;
(ii) positive when debt/preferred stock is exchanged for common and negative
when common stock is exchanged for debt/preferred stock;
(iii) positive when common stock is repurchased (by tender offer/open market
repurchase);
(iv) negative for convertible debt/preferred stock calls forcing conversion into
common;
(v) positive for withdrawals or cancellations of common stock offerings; and
(vi) nonnegative for adoptions of DRIPs and ESOPs.
In the remainder of this section, we examine a number of competing hypotheses

to explain this evidence: These hypotheses include (1) optimal capital structure
effects, (2) asymmetric information and implied cash flow effects, (3) adverse
selection effects, (4) effects of changes in ownership structure, and (5) effects of
partial anticipation of SPOs.
4. 2. Optimal capital structure effects
Theories of optimal capital structure generally imply a nonnegative market

reaction to capital structure changes. These theories emphasize various debt and
equity issuance trade-offs such as between the corporate tax advantage of debt and
the costs of financial distress [Kraus & Litzenberger, 1973; Brennan & Schwartz,
1978], the personal tax disadvantage of debt and the impact of excess corporate
tax deductions on the corporate tax advantage of debt [Miller, 1977; DeAngelo &
Masulis, 1980], agency costs of debt and equity [Jensen & Meckling, 1976; Myers,
1977], and the effect of debt on the firm's competitive product market strategy
[Brander & Lewis, 1987; Maksimovic, 1988]. In the presence of transaction costs,
optimal capital structure adjustments (i.e., movements along a concave leverage-
value function) are observed only when the benefit of the adjustment exceeds
the required transaction cost [Fischer, Heinkel & Zechner, 1989], causing a
nonnegative announcement effect.
The evidence of a nonpositive market reaction to SPO announcements of
both debt and equity, and to equity-for-debt exchange offers and swaps, fails to
support these optimal capital structure effects. However, as pointed out by Masulis
[1983], tests of optimal capital structure effects using offer announcements are
complicated because these announcements can also indicate to the market a shift
in the issuer's economic situation which implies that the issuer's leverage-value
function has shifted. 13 In addition, stock offers are often quickly offset by debt
offers or additions of other types of debt. Thus, the long term leverage change
is unlikely to be closely related to the equity issue induced leverage change. It
is therefore unclear to what extent the theories of optimal capital structure can
explain the evidence in Tables 11 and 12.
4.3. Asymmetric information and cash flow effects
In a world where managers have information about the firm that the market
does not have, 'pure' capital structure changes are unlikely. 14 In this case, the
announcement effect of a planned security offer will reflect the economic impact
of the capital structure change conditional on the market's estimate of the change
in managers' private information implied by the voluntary corporate decision.
Assuming it is prohibitively costly for low-quality firms to perfectly mimic high-
quality firms, signalling models of Ross [1977], Leland & Pyle [1977], Heinkel
[1982], and John & Williams [1985] imply that leverage-decreasing corporate
events signal negative revisions in management expectations concerning the firm's
future cash flows, thus causing a negative revaluation of the firm's shares. The Ross
[1977] and Heinkel [1982] models symmetrically imply that leverage-increasing
capital structure changes signal positive information about firm value, and result
in positive announcement effects. The average market reaction to exchange offers"
shown in Table 12 is consistent with these predictions, while the nonpositive
market reaction to public offers of debt for cash in Table 11 is inconsistent. Thus,
the evidence regarding the relevance of the above signalling theories is mixed.
13See also Smith [1986] on this point.

14A 'pure' capital structure change is one which does not alter the market's perception of the
issuing firm's real asset compositionor investment policy.
Since SPOs for cash alter the issuer's current cash flow, these events provide in-
sights concerning the empirical relevance of an alternative asymmetric information
model of Miller & Rock [1985]. In their model, any larger-than-expected external
financing by the firm reveals a smaller-than-expected current operating cash flow,
which constitutes negative news to the market about current and expected future
cash flows. Under this theory, the security offer announcement decreases the is-
suer's market price regardless of the direction of the implied leverage change. The
significant negative market reaction to common stock and convertible debt issue
announcements is consistent with this argument, while the insignificant market
reaction to straight debt and preferred stock issue announcements is inconsistent.
The Miller-Rock model also implies that the market reaction to external financing
is more negative the greater the size of the offer. This prediction is supported
by cross-sectional regressions of the market reaction to equity offers reported in
Masulis & Korwar [1986] and Eckbo & Masulis [1992], but receives no support
in the cross-sectional regressions of the market reaction to straight debt offers
reported in Eckbo [1986].
Studies of post-issue changes in earnings provide additional perspective on
the hypothesis that the negative valuation effect of firm commitment offers
reflects expectations of lower future cash flows. Hansen & Crutchley [1990]
examine abnormal earnings changes over several years subsequent to common
stock, convertible debt and straight debt offerings. They report abnormal earnings
declines following all three forms of financing. However, straight debt appears to
be used after the abnormal earnings decline has been ongoing. In contrast, equity
issuers finance in advance of earnings declines. Examining abnormal earnings
declines over the subsequent three year period, they report that earnings are
significantly more negative for common stock offerings and for relatively larger
offerings of securities. Brous [1992] and Jain [1992] report that following common
stock offers there are significant downward revisions in analysts' one year earnings
forecasts and the size of the revisions is positively related to announcement
returns.
Israel, Ofer & Siegel [1989] examine revisions in Valueline earnings forecasts
following equity for debt swaps, which are an indirect method of equity issuance.
They report that earnings forecasts are revised downward following the equity
for debt swap. Furthermore, when firms repurchase shares in a tender offer,
Hertzel & Jain [1991] report evidence that these announcements cause positive
revisions in Valueline earnings forecasts. Investigating stock repurchases by tender
offer, Dann, Masulis & Mayers [1991] report several forms of evidence of an
increase in unexpected earnings. Overall, the evidence on post-offer earnings
changes suggests that the market reaction to the issue announcement in part
reflects market anticipation of future cash flow changes. This is supportive of the
adverse selection model of the issuance process discussed below. However, direct
evidence to support this conjecture is mixed as both Eckbo [1986] and Hansen
& Crutchley [1990] fail to find a significant cross-sectional correlation between
the announcement effect and future abnormal earnings, while Dann, Masulis &
Mayers [1991] report a marginally significant relationship.
4. 4. Adverse selection effects"
In the adverse selection model of Myers & Majluf [1984], the issuing firm
knows more than the market about the true value of the issuer's assets in place.
Assuming managers have an incentive not to sell underpriced securities, the
market now demands a price discount in order to hedge against the risk that the
security offered is overvalued. 15 Krasker [1986] extends the Myers-Majluf analysis
to allow managers to choose an offer's size and shows that firms with overpriced
stock will have greater incentives to choose larger offers. Adverse selection effects
are also caused by the underwriter's ability to allocate shares to its preferred
clients in oversubscribed offers [Benveniste & Spindt, 1989], and by the presence
of differentially informed investors which cause underpriced new issues to be
oversubscribed while overvalued offers are not [Rock, 1986].
There are several potential solutions to the adverse selection problem which
could in principle eliminate the cost borne by the high quality marginal issuer of
stock. These include changing managerial incentives through compensation con-
tracts [Dybvig & Zender, 1991]; issuing common stock through nontransferable
rights to existing stockholders [Eckbo & Masulis, 1992]; communicating private
information to the market through reliable financial intermediaries such as in-
vestment bankers who have built a reputation for truthful information disclosure
[Booth & Smith, 1986; Titman & Trueman, 1986]; using private placements where
sophisticated investors have access to proprietary firm information [Wruck, 1989];
maintaining excess financial slack (i.e., internally generated funds and a capacity
to issue risk-free securities, as proposed by Myers & Majluf); and selling securities
in separately incorporated subsidiaries termed 'equity carve-outs' in order to avoid
some of the information asymmetry associated with buying residual claims in
the parent company [Schipper & Smith, 1986; Nanda, 1991]. Also, Stein [1992]
argues that issuing callable convertible debt instead of stock can lower the adverse
selection problem, though not eliminate it.
The empirical evidence concerning the average market reaction to SPO announce-
ments, summarized in Observation 14 above, is largely consistent with the adverse
selection framework. That is, SPOs have nonpositive effects regardless of security
type, and the average market reaction to equity issues is more negative the larger
the issue and less negative the less risky the security issued. Moreover, the market
reaction to equity issues is less negative for uninsured rights than for standbys, and
is less negative for standbys than for firm commitment offers. This ordering of av-
erage announcement effects is consistent with the Eckbo & Masulis [1992] adverse
selection model for the flotation method choice discussed in Section 5 below.
Furthermore, there is typically less adverse selection risk associated with a public
utility issue than with an industrial issue. The investment and financing decisions of
utilities are highly regulated, and public knowledge of regulatory policy lowers the
probability that a utility announcing a stock offer is attempting to take advantage
~5An extensivediscussion of adverse selection models is presented in Kent Daniel and Sheridan
Titman [1995, this volume].
of an informational asymmetry in the stock market. For example, stock offers

may require state utility commission approval or SEC approval for utility holding
companies. It also appears that state regulatory commissions often pressure
utilities to make equity offers by withholding rate increase approval unless equity
issues are made, which further lowers the anticipated adverse selection effect of
such actions. Consequently, the adverse market reaction to a public sale of equity
should be smaller for public utility issues than for industrial issues, as observed
for firm commitment offers [Asquith & Mullins, 1986; Masulis & Korwar, 1986]
and rights/standby offers [Eckbo & Masulis, 1992]. Similarly, the shelf registration
procedure, which allows the issuer greater flexibility in terms of timing the equity
offer, increases adverse selection effects and is found on average to cause larger
negative announcement effects [Bhagat, Marr & Thompson, 1985; Denis, 1991].
4. 5. Effects of changes in ownership structure
A large stock ownership position subjects the manager to the loss of significant
diversification, so increasing management stock ownership acts as a credible signal
of firm quality [Leland & Pyle, 1977; Grinblatt & Hwang, 1989]. On the other
hand, owner/manager sales of equity in IPOs or SPOs creates greater incentives
for managers to sell overvalued stock to outsiders. ~6 This is one explanation
for the finding of Masulis & Korwar [1986] that combination primary-secondary
offers where management is lowering the dollar investment in the stock cause
relatively large negative announcement returns.
Wruck [1989] examines announcements of private placement sales of common
stock and finds a significantly positive 4.5% average announcement return. Unlike
public stock offers, private placements tend to increase shareholder concentration.
For firms with relatively low or high initial shareholder concentration , the offer-
induced increase in shareholder concentration is positively related to the stock's
announcement return. Private placements are also likely to minimize the potential
asymmetry of information between the purchaser and the issuer of the stock since
the private placement gives investors access to the issuer's operations and financial
condition.
Using a sample of Canadian security issues, Eckbo & Verma [1992] test whether
the market reaction to various forms of SPOs is driven by the implied change in
the distribution of voting rights. Their tests are in part motivated by the theoretical
work of, e.g., Harris & Raviv [1990], Stulz [1990], and Israel [1992], who link the
firm's capital structure choice to corporate control considerations. For example,
insiders may retain a certain fraction of the voting rights in order to maximize
the value of the voting premium during a future takeover contest for the firm.
Controlling for the distinction between equity and debt, Eckbo & Verma find some
evidence that the market reaction to an offer announcement is more negative the
greater the dilution of voting rights caused by the offering.
1c,Karpoff & Lee [1991] and Bchren, Eckbo & Michalsen [1992] report that insiders on average
sell stock prior to stock offers.
4. 6. Effects of partial anticipation
To the extent that security offerings are predictable events, the announcement
effects of SPOs listed in Table 11 reflect only the unanticipated component of
the total valuation impact. This may not be a serious concern for most equity
issues since these are relatively infrequent [Mikkelson & Partch, 1986]. However,
some public utilities make frequent common stock offerings which should depress
the likely market reactions to these events. On the other hand, debt issues
are much more frequent than equity, and are in part predictable based on the
known maturity structure of the firm's outstanding debt. Thus, it is possible
that the generally insignificant announcement effect of debt offerings reflects an
attenuation bias due to market anticipation of the issue rather than an inherently
insignificant economic event per se.
Bayless & Chaplinsky [1991] provide some perspective on this question by
developing a debt and equity offer prediction model. Their logit prediction model
includes as explanatory variables stock risk measures, the firm's tax paying status,
deviation of leverage from its long term level, proportion of intangible assets, the
change in the stock's price, the change in stock market index and the change
in interest rates. Using this model to classify announcements, they separately
examine the price effects of debt and equity offer announcements according
to whether or not the same type of security offer is predicted. They find that
equity announcement effects are more negative when debt is predicted, while
debt announcement effects are Positive when equity is predicted and negative
but close to zero when debt is predicted. Bayless & Chaplinsky also estimate
cross-sectional regressions of the equity and debt offer announcements and find
additional support for their event study results. Their findings are further evidence
that firm commitment stock offers -but not debt offers-are greeted negatively by
the market. 17
Jung, Lee & Stultz [1992] also examine the predictability of debt versus equity
offers. They report that' Tobin's q, prior cumulative stock returns, tax payments
divided by total assets and the index of leading indicators of economic activity are
important predictive variables, which allow the debt-equity choice to be predicted
with a large degree of accuracy once we condition on one of these securities issues
being announced.
5. The choice of equity flotation method
5.1. Rights vs. underwritten offers
In Section 3, we observed that direct flotation costs of seasoned equity offers

differ significantly across flotation methods, with the costs being highest for indus-
trial firm commitment offers (on average 6% of offering proceeds for industrial
17Also see Jung, Kim & Stultz [1991].

issuers), lowest for uninsured rights (on average 1%), and with standby costs in
between (on average 4%). Furthermore, the evidence in Section 4 indicates that
the average market reaction to seasoned equity offers depends significantly on
the flotation method. For example, the dollar value of the - 3 % average two-day
announcement period price drop associated with firm commitment offers is equiv-
alent to a loss of approximately 25% of the proceeds of the average issue. In
contrast, there is no such economically significant price drop for the average rights
issue, and only a moderate price drop for standby offers.
Thus, the choice between rights and underwritten offers significantly affects
the total wealth effect of the equity issue decision. Heinkel & Schwartz [1986]
and Eckbo & Masulis [1992] model this choice assuming the issuer is better
informed than investors about the true value of the shares sold. In the H e i n k e l -
Schwartz model, firms (1) sell the issue immediately to an uninformed underwriter
for a nominal firm commitment fee, (2) select a standby rights offer where the
underwriter charges an additional investigation cost in order to become sufficiently
informed to correctly price the put option implicit in the standby underwriting
contract, or (3) use uninsured rights and risk incurring a fixed failure cost if the
issue is undersubscribed. In their model, the investigation cost associated with
the standby contract helps separate high-quality from low-quality issuers. Thus, in
equilibrium, only the highest quality issuers select the standby contract, the lowest
quality firms select direct sale to the underwriter, while intermediate-quality
issuers select uninsured rights.
The flotation cost structure assumed in the Heinkel & Schwartz model is,
however, inconsistent with the evidence that firm commitment contracts are more
expensive than standby contracts. Second, since only the highest quality firms elect
to pay the investigation costs implied by a standby offerings the market reaction to
the issue announcement is predicted to be most favorable for standby contracts,
least favorable for firm commitments, with uninsured rights in between. This is
also inconsistent with the evidence that uninsured rights issue announcements are
associated with the most favorable market reaction.
Third, the Heinkel-Schwartz model implies that a rights issuer who privately
expects the stock price to fall over the rights offer period will select a relatively
low subscription price relative to the current market price in order to insure
against offer failure. Consequently, market participants infer the issuer's private
information from the magnitude of the offer price discount, with greater discounts
causing larger downward adjustments in the stock's secondary market price.
However, while this explanation for the apparent reluctance of managers to issue
rights with a deep subscription price discount is interesting, it receives no direct
support fi-om cross-sectional regressions of the offer-day abnormal stock return on
the offer price discount [Eckbo & Masulis, 1992]. 18
18 Hietala & L6yttyniemi [1991] point to another signalling effect which can occur in an
institutional setting such as the Finnish stock market, where firms apparently set their dividends as
a percent of the par value of common stock. Since a stock issue does not change the par value,
it implies a dividend increase unless the issuer simultaneously reduces the percentage dividend..If
E c k b o & Masulis [1992] present an alternative model for the flotation method
choice which builds on the Myers & Majluf [1984] adverse selection model where
a firm faces a profitable investment opportunity that requires a commonly known
level of new equity capital. The firm's decision to issue and invest depends on
the value of the project, b, the cost of selling under or overpriced stock, c, and
direct flotation costs, f . Managers, who are assumed to maximize the intrinsic
(full information) value of the firm's shares, elect to issue and invest if and only if
the net issue benefit is nonnegative, that is, when b - (c + f ) > 0. Thus, a decision
to issue generally signals a truncation of the upper tail of the distribution of share
intrinsic values.
T h e E c k b o - M a s u l i s model differs from the Myers-Majluf framework in that
managers can select from alternative flotation methods including rights offers
where current shareholders can subscribe to the issue, and standby and firm
c o m m i t m e n t methods where underwriters have some ability to evaluate and
credibly certify the true quality of the shares sold. 19 Stock sales to current
shareholders are essentially treated as another source of 'financial slack' (i.e.,
exogenously given internal sources of funds), which reduces the size of the issue
offered to outside investors. As in the Krasker [1986] model, a smaller sale of
stock to outside investors lowers the expected adverse selection effect. Thus,
the selection of a rights offer or standby offer m e t h o d potentially allows for
partial separation where higher quality issuers can pool together, provided that a
significant portion of the issue is taken up by existing shareholders.
The expected takeup level, k, is assumed to be exogenously determined by
individual shareholder considerations. Rights offers dominate underwritten offers
only when k is high, i.e., when existing shareholder takeup substantially reduces
the size of the issue sold to outside investors. Firms faced with low k can find
costly certification to be attractive because some lowering of adverse selection
is obtained as some overpriced issues are detected by the underwriter and
forced to lower their offer prices or withdraw their issues. In addition, issuers of
overpriced stock find firm commitments attractive because if they go undetected
as overpriced, then the current shareholders realize greater wealth gains from the
stock issue decision. Standbys dominate firm commitments for low-k firms as long
as k is sufficiently large to justify the direct costs of distributing the shares to
existing shareholders.
T h e model predicts that (1) issuers select uninsured rights only if k is high
managers are reluctant to cut the dividend (e.g., due to information effects), a stock issue under
these conditions should provide a positive signal to the market, and the signal should be increasing
in the offer price discount (a deeper discount necessitates issuance of more shares to raise a given
amount of capital). Hietala & L6yttyniemi present evidence which supports this prediction.
19This is consistent with models such as Booth & Smith [1986], Beatty & Ritter [1986], and
Titman & Trueman [1986], where the underwriter is given some ability to evaluate the extent to
which the stock is over or underpriced and is given an incentive to use this information to avoid
selling significantly overpriced stock to the public. In addition to reputation considerations, due
diligence and legal liability also help induce the underwriter to avoid overpriced issues [Tinic, 1988;
Blackwell, Marr & Spivey, 1990].
and the stock is not greatly overvalued; (2) issuers selecting standbys have both
a higher value of k and are of a higher average quality than firms selecting firm
commitments; and (3) the average market reaction to an offer announcement will
be least negative for uninsured rights and most negative for firm commitments,
with standbys in between.
These predictions of the Eckbo & Masulis model are supported by the empirical
evidence summarized in Table 11. They are also supported by their evidence that
uninsured rights, but not standbys or firm commitments, are typically accompanied
by announcements of substantial shareholder subscription precommitments which
serve to credibly signal the issuer's high k-value. Furthermore, BOhren, Eckbo &
Michalsen [1992] estimate the value of k and find that the probability that a rights
offer is underwritten decreases significantly with the est;mate of k, as predicted by
Eckbo & Masulis.
Moreover, to the extent that the value of k decreases as the firm's equity
capitalization and degree of share-ownership dispersion increase, the Eckbo &
Masulis analysis suggests that the frequency of rights offers should be higher for
relatively small, closely held firms. They present evidence on industrial issuers
which supports this prediction. The fact that smaller, private companies use the
rights method more frequently than publicly traded firms is also consistent with
this size argument. This may also explain the greater use of rights in foreign
jurisdictions (including Canada and most countries in Europe and the Pacific
Basin) characterized by smaller and relatively closely held firms.
Furthermore, for a given value of k, the Eckbo & Masulis model suggests that
the greater the information asymmetry between the issuer and the market, the
greater the marginal benefit of quality certification, and the greater the probability
that the issuer will employ an underwriter. Thus, issuers with a relatively transpar-
ent production technology, or a high level of mandated disclosure, which reduces
information asymmetries between the firm and the market, are more likely to use
rights. Thus, regulated utilities, with the greater level of public information and
less discretion in terms of the timing of a new issue, are more likely to select
rights. This prediction is supported by the evidence on offer frequencies across
industrial and utility equity issuers in Table 6.
Since firms switching from rights to firm commitment offers must first eliminate
corporate charter provisions granting shareholders preemptive rights to purchase
new equity issues, the Eckbo-Masulis model also has implications for the timing
of preemptive rights charter amendments. That is, as the value of k falls (perhaps
because firm size grows with time), managers find it optimal to switch to firm
commitment offers and therefore propose preemptive rights charter amendments.
According to the sample of preemptive rights charter amendments in Bhagat
[1983], there was a surge in such amendments early in the 1970s, just preceding
the sharp reduction in rights issues shown in our Table 6. Moreover, the model
predicts a negative market reaction to announcement of preemptive rights charter
amendments. The charter amendment proposal signals management information
on k, causing the market to capitalize the higher future expected costs of raising
capital. The evidence in Bhagat [1983] is consistent with this prediction as well.
The above empirical observations can be summarized as follows:
Observation 17 Rights. vs. underwritten offers'. In Eckbo & Masulis [1992], a rights
issue where current shareholders elect not to subscribe causes the market to
infer that the firm is of relatively low quality, resulting in relatively large adverse
selection costs of the type analyzed in Myers & Majluf [1984]. Current shareholder
takeup reduces adverse selection costs, as does costly quality certification by
underwriters. In this framework,
(i) expected shareholder takeup is an important determinant of the flotation
method choice;
(ii) firms selecting uninsured rights sometimes use shareholder subscription pre-
commitments to credibly signal a high shareholder takeup;
(iii) firms tend to switch to underwriting as the firm's ownership structure be-
comes dispersed (as with most publicly traded firms);
(iv) firms with less discretion over their issue policy, such as regulated utilities,
tend to use rights more often than unregulated firms; and
(v) the market reacts most negatively to firm commitment offers, least negatively
to uninsured rights, with the market reaction to standby offers in between.
All of these predictions are supported by empirical evidence.
5.2. Best efforts vs. firm commitment underwriting contracts
The Eckbo-Masulis analysis can be applied to other flotation methods. For ex-
ample, low-k firms who derive only a small certification benefit from underwriting
because the true quality of the issuer is relatively transparent to the market (there
is little to certify) may select the cheaper best efforts underwriting contract over
firm commitment underwriting. Interestingly, only regulated utilities, which have
relatively low adverse selection effects, use the best efforts method for issuing
SPOs with any frequency.
The choice between best efforts and firm commitment contracts has also
been analyzed in the literature on IPOs where best efforts are much more
frequent (approximately 40%). Building on the underpricing model of Rock
[1986], Ritter [1987] argues that uninformed investors view the minimum investor
takeup requirement that characterizes best efforts contracts as a substitute for
underpricing. A minimum takeup requirement implies that the issuer precommits
to withdrawing the issue if demand is insufficient to meet the requirement. Since
informed investors do not subscribe to overpriced issues, the minimum takeup
requirement tends to release uninformed investors from their obligation to accept
their share allocation precisely when the issue is overpriced and likely to be
partially sold.
Viewing a firm commitment contract as essentially a best efforts contract with a
zero minimum sales requirement, the issuer in Ritter's model determines the opti-
mal underwriting contract by trading off the cost of underpricing with the increased
risk of offer failure caused by a minimum sales requirement. He shows that the
most risky issuers are more inclined to select best efforts contracts, while less risky
issuers select firm commitments. Intuitively, since the necessary winner's curse un-
derpricing [Rock, 1986] is highest for the riskiest issuers, they benefit most by
offering the minimum sales requirement as an insurance to uninformed investors.
Welch [1991] performs cross-sectional regressions with IPO underpricing as de-
pendent variable and finds that the coefficient on the minimum sales requirement
variable is significantly positive, and that proxies for the risk of the issue have
no significant impact on underpricing. Both findings are inconsistent with Ritter's
model. Welch interprets the positive impact of the minimum sales requirement as
consistent with the model of Benveniste & Spindt [1989], where a larger investor
takeup requirement induces greater preselling activity by the underwriter which in
turn requires greater underpricing.
6. The timing of SPOs
Given that equity offers occur relatively infrequently for the typical industrial
firm, it is also important to understand the determinants of the timing of these
offers. A number of theories have been posited to explain the timing of equity
offerings, several of which take into account the phase of the business cycle that
exists or is expected. In Choe, Masulis & Nanda [1993], an adverse selection
argument similar to Myers & Majluf [1984] is developed where firms choose
between issuing debt and equity across business cycle expansions and contractions.
As discussed earlier, in the Myers & Majluf model, managers want to issue
stock when it is overvalued and avoid issuing it when it is undervalued. However,
profitable investment projects exist that would be lost if the equity issue is delayed
or foregone. This causes some but not all firms with undervalued stock to issue
equity, avoiding a market breakdown of the type explored by Akerloff [1970].
Nevertheless, firms with especially undervalued stock continue to find it optimal
to forego the investment opportunity, and an adverse selection effect is generated.
Choe, Masulis & Nanda observe that since expansions involve more profitable
investment opportunities, firms are less likely to forego investments because the
stock is underpriced. Thus, they predict that adverse selection effects of equity
offers will be smaller in economic expansions and, therefore, the frequency of
equity offers greater. There is empirical support for these arguments in Moore
[1980] and Choe, Masulis & Nanda who find that the frequency of equity offers
relative to debt offers rises in expansions, while the magnitude of the negative
stock price reaction to firm commitment equity offer announcements decreases. In
contrast, debt issues are insensitive to this equity mispricing effect. The evidence
in Choe, Masulis & Nanda, Taggart [1977] and Marsh [1982] indicates that the
number of straight debt offers do not fall in economic contractions and may
rise after interest rates have fallen. This latter effect may in part reflect debt
refinancing activities in these periods.
The Choe-Masulis-Nanda model also predicts that the adverse selection effect
increases as investor uncertainty concerning the value of assets in place rises.
Schwert [1989] documents that stock price volatility varies over the business
cycle, increasing during recessions. 2° Controlling for the effect of the business
cycle, Choe, Masulis & Nanda find that the relative frequency of equity issues is
significantly negatively related to the variance of issuer's daily stock returns, which
gives further empirical support to their adverse selection framework.
Several other hypotheses concerning the timing of equity offers can be extended
to a business cycle environment. For example, under Myers' [1984] 'pecking order'
hypothesis, firms are viewed as preferring to finance projects internally if possible,
otherwise to issue low risk debt and finally to issue equity only as a last resort.
Imposing an arbitrary limit on firm leverage, the timing of equity issues is affected
by business cycle downturns that reduce internal sources of funds and raise
leverage by lowering asset values, thereby making equity offers more attractive.
However, this scenario is inconsistent with the evidence found in Choe, Masulis &
Nanda.
Another hypothesis is based on debt-equity wealth transfers occurring when
leverage is unexpectedly revised. If a firm issues equity, thus lowering firm leverage,
debtholders gain in that their risk bearing falls while their risk premium contin-
ues to be paid in full. This tends to discourage management seeking to maximize
shareholder wealth from undertaking equity offers, except when leverage has be-
come unacceptably high. In economic contractions, debtholders bear greater risk
and expect greater risk premiums. So, in downturns equity offers cause leverage
reductions resulting in larger reductions in debt riskbearing, which lead to greater
debtholder wealth gains. Thus, there are greater costs to equity issues in economic
downturns, leading to a lower predicted frequency of equity offers and a more
negative stock price reaction. However, the positive price reaction of the issuer's
outstanding debt to an equity offer announcement, predicted by the wealth transfer
hypothesis, is not observed by Kalay & Shimrat [1987].
In the Stulz [1990] model of 'free cash flow', debt issuance becomes more
attractive when free cash flow increases. In economic contractions, if earnings
decline less sharply than capital spending, which is typically the case, free cash
flow can increase, increasing the attractiveness of debt offers. The cost of debt
issuance in the Stulz model is underinvestment in profitable projects which would
tend to be less of a problem in economic downturns. Thus, debt issuance would
appear to be predicted to rise in frequency, near contractions under the Stulz
model, which is contrary to the Marsh [1982] and Taggart [1977] evidence but
somewhat supported by the Choe, Masulis & Nanda [1993] evidence. It is also
supported in a recent study by Jung, Lee & Stulz [1992] who report that firms with
relatively good investment opportunities measured by Tobin's q, are significantly
more likely to issue equity over straight debt.
Another hypothesis that predicts variation in equity and debt offers over
time is the belief of many practitioners that management prefers debt issuance
when interest rates are historically low and stock issuance when stock prices are
historically high, provided that either risk premiums are relatively low or expected
20Schwert links this volatility increase to increases in operating leverage, which is likely to be
positivelyrelated to investor uncertainty concerningthe value of assets in place.
returns are high. Since stock market prices tend to reflect future economic
prospects, this hypothesis tends to predict increases in equity offers in economic
expansions and debt issues in economic contractions when interest rates tend to
be lower. This is consistent with the Marsh and Taggart evidence but only partially
consistent with the Choe, Masulis & Nanda evidence.
Lucas & McDonald [1990] develop a dynamic model of the equity issuance
process that predicts a greater frequency of equity issuance following a general
stock market increase. As in Choe, Masulis & Nanda, temporarily underpriced
firms have an incentive to postpone the issue until the stock price is higher, which
implies that the average preannouncement price path of these issuing firms will
be upward sloping. On the other hand, temporarily overpriced firms will issue
immediately as investment opportunities arise. If the arrival of investment projects
is uncorrelated with the firm's price history, then the average preannouncement
price path of temporarily overvalued firms will be flat. As a result, the average
preannouncement price path of all issuing firms will be upward sloping, as is
typically observed in samples of firm commitment offers [Asquith & Mullins, 1986;
Masulis & Korwar, 1986; Choe, Masulis & Nanda, 1992; Taggart, 1977; and Marsh,
1982]. Also, the Lucas & McDonald argument implies that market reaction to the
issue announcement will be more negative for firms with higher stock price rises
over the preannouncement period, which is supported by the regression results
of Masulis & Korwar [1986], Korajczyk, Lucas & McDonald [1990], Eckbo &
Masulis [1992], and Jung, Lee & Stulz [1992].
Eckbo & Masulis [1992] note that the effect of increased shareholder participa-
tion in the equity issue is to reduce the incentive of undervalued firms to postpone
equity issuance since current shareholders capture part of the underpricing. At
the extreme, when current shareholders purchase the entire issue, the firm issues
immediately regardless of its current degree of underpricing. Thus, in a sample
of issuers where the average level of shareholder participation is known to be
large, the Eckbo & Masulis model predicts that there should be little or no stock
price runup prior to the issue announcement. This prediction is supported by
their evidence of little or no prior runup in the sample of uninsured rights, and
a smaller runup prior to the announcement of standby rights than prior to firm
commitment underwritten offers.
Finally, Korajczyk, Lucas & McDonald [1992] propose a short run adverse
selection model which predicts that equity issues will occur less frequently prior
to accounting earnings releases and more frequently after these releases. This
follows because the uncertainty about the value of the assets-in-place is lowered
with the accounting releases, thereby lowering the market's concern over adverse
selection effects. Dierkens [1991] and Korajczyk, Lucas & McDonald [1991]
present evidence which supports this argument.
Observation 18 Timing of equity issues. Several models predict that the frequency
of equity and debt offers will vary with the business cycle and with the prior
stock price history of the security issued. Several pieces of evidence support these
predictions:
(i) the frequency of equity issues tends to rise during economic expansions;
(ii) the magnitude of the negative market reaction to firm commitment offers of
equity decreases in expansions;
(iii) equity issues occur more frequently after accounting earnings releases; and
(iv) on average, firm commitment issues of common stock occur after a significant
runup in the issuer's secondary market price, while no such runup is observed
prior to equity rights issues.
7. M a r k e t m i c r o s t r u c t u r e effects
Seasoned public offers of common stock have important impacts on the sec-
ondary market in which the common stock trades. The typical firm commitment
offer involves a large increase in shares outstanding along with a large increase
in the number of stockholders and a reduction in management and blockholder
percentage ownership. As a result, one would anticipate that there would be major
increases in trading volume, a lower percentage of insider trading and possibly
major changes in price volatility after the public offering.
Theories of bid-ask spread determination are based on adverse selection and
inventory cost considerations. These theories predict that if trading volume rises
and price volatility falls, then bid-ask spreads will also fall since the expected
costs of market making decline. The SPO announcement per se can also lower
the asymmetric information about the firm's stock price borne by market makers,
which would cause bid-ask spreads to drop further.
Amihud & Mendelson [1986] develop a valuation model of security pricing
that assumes that investors have a positive preference for liquidity measured by
percentage bid-ask spread. They derive a model of security pricing where the
expected return is a positive and concave function of bid-ask spread. Amihud &
Mendelson [1988] extend the implications of the model and present evidence that
liquidity is an important determinant of security value. They argue that managers
seeking to maximize current stockholder wealth should take market liquidity into
account when making corporate financing decisions. Thus, in deciding whether to
make an SPO and in choosing the flotation method, liquidity implications need to
be taken into account. A further implication is that the negative adverse selection
effect of the offer announcement can be partially offset by the positive liquidity
effect.
Lease, Masulis & Page [1992] explore the market microstructure effects of
firm commitment SPOs for NYSE and A M E X listed firms. They document that
share trading volume on average rises substantially and that price volatility falls
subsequent to the SPO. In exploring this question, Lease, Masulis & Page find
that both dollar bid-ask spreads and percentage spreads fall significantly after
the seasoned public offering, consistent with existing inventory cost and adverse
selection cost models of bid-ask spread determination. They also investigate how
these variables change between the announcement and the offer dates. They
report that trading volume and price volatility fall in the interim. In addition,
1060 B.E. Eckbo, R. IV..Masulis
bid-ask spreads drop but not to the level observed subsequent to the public offer.
This is suggestive of a modest lowering of the adverse selection effect borne by
market makers following the SPO announcement.
In two related studies, Loderer & Sheehan [1992] and Tripathy & Rao [1992]
examine the market microstructure effects of SPOs for NASDAQ listed firms.
Loderer & Sheehan report that the number of shareholders, number of market
makers and share trading volume rise, and bid-ask spreads rise slightly at the SPO
announcement and fall subsequent to the public offering date.
Tripathy & Rao [1992] separate their NASDAQ SPO sample into large and
small capitalization stocks. They find that larger stocks have increases in bid-ask
spread over a 60-day period prior to the announcement followed by decreases
in spread over the next 43 days. In contrast, small stocks experience increases
in spread from 80 days prior to the announcement through 20 days after the
announcement. Focusing on the public offering date, they find that the bid-ask
spreads of large stocks decrease over the 20 days prior to the offering and decrease
even more over the 20 days following the offer. Spreads of small stocks increase
over the 20 days prior to the offering but then decrease from just before the offer-
ing through 20 days after. This suggests that information asymmetries decrease for
large firms once the investment bankers begin their due diligence investigation.
However, for smaller firms this information asymmetry does not appear to fall
before the public offering date. The major results of these two NASDAQ studies
are generally consistent with the findings of the prior NYSE/AMEX study.
Kothare [1993] examines the market microstructure effects of rights offers from
the perspective that these offers have a stock split embedded in them. Since stock
splits are known to have market microstructure effects [Copeland, 1979; Brennan
& Copeland, 1988], rights offers are likely to have them as welt. Kothare finds that
rights offers result in higher bid-ask spreads both before and over the rights offer
period, and a small reduction thereafter, unlike firm commitment offers which
experience substantial declines in spread following the SPO.
Stock offers can also cause temporary biases in daily stock returns by disrupting
normal buy-sell order flow in the secondary market. Lease, Masulis & Page [1991]
document that around the public offer dates of SPOs stock returns are biased
downward due to the loss of purchase orders to the temporary primary market
in the stock. One result is that the transaction prices in the stock tend to occur
at the lower ask quote, rather than at the midpoint of the bid and ask, which
generates an apparent fall in the stock price. There is also evidence that market
makers lower their quotes in this period due to a positive imbalance in their
inventory position resulting from the predominance of sell orders at this time.
Lease, Masulis & Page find that using the closing bid-ask average rather than
the closing transaction prices eliminates the statistical significance of the drop and
reduces by more than half the average negative offer date return.
Observation 19 Effects of seasoned equity offers on bid-ask spreads. Percentage

bid-ask spreads of common stocks having firm commitment SPOs drop signifi-
cantly before and after the public offering date. This post offer phenomenon in
part reflects the increase in shareholders and trading volume which occurs after
the SPO. Percentage bid-ask spreads of common stocks having equity rights offers
increase before and during the rights offer period and decrease only slightly there-
after. A firm issuing by means of a rights offer can be viewed as experiencing a
stock split which tends to increase percentage spreads, while the resulting increase
in shareholders and trading volume is substantially less than in firm commitments.
Also, the offering date return exhibits a significant negative bias due to the
preponderance of sell orders received in the secondary market.
8. Conclusions
Over the past decade, our understanding of the various contractual arrange-
ments in the corporate capital acquisition process, and the influence of this
process on corporate financial and investment policy, has progressed substantially.
As summarized in the Appendix, we have identified nineteen groups of empirical
observations which form perhaps the core of our empirical understanding of how,
by how much and when corporations make seasoned public offerings of equity.
The results indicate that, since World War II, internal equity (retained earnings
including depreciation) has remained the dominant funding source for nonfi-
nancial corporations in all the industrial countries studied. Debt has been the
dominant external funding source, with a steady increase in leverage ratios in the
U.S. from a low of 30% in 1946 to approximately 60% in 1984. The ratio of public
debt to public equity issues tends to decrease during business cycle expansions
and to increase during business cycle contractions. While the U.S. has traditionally
been the country with the largest volume of equity issues, the volume of equity
issues by European nonfinancial corporations had by 1987 grown to more than
twice the corresponding volume in the U.S. and in Japan, in part due to major
privatization programs of government owned firms.
Both in the U.S. and internationally, there is a trend towards selecting un-
derwritten flotation methods when issuing equity as well as other more senior
securities. In the U.S., this trend caused the rights offer method to virtually disap-
pear by the early 1980s, while rights offers still count for the majority of domestic
equity issues in the Canadian, the European and most Pacific Rim capital markets.
In Japan, the majority of equity issues are now sold through the firm commitment
underwritten method. In the U.S., the demise of the rights issue has coincided
with a surge in DRIPs and ESOPs, which are in some ways similar to periodic
rights offers.
The trend towards greater use of underwritten offers occurs despite substantial
evidence that the direct flotation costs associated with the uninsured rights method
are significantly lower than the underwriter fee. This 'rights offer paradox' may
in part be resolved by considering shareholder-borne costs of the rights method
which are not included in traditional measures of direct flotation costs but which
tend to reduce the attractiveness of rights for value-maximizing managers of
issuing firms. While the evidence here is relatively sparse, these additional costs
include capital gains taxes, reduced stock liquidity and transaction costs of selling
rights in the secondary market, risk of offer failure and wealth transfers to
convertible security holders triggered by anti-dilution clauses in these contracts.
Eckbo & Masulis [1992] also point out potentially large adverse selection costs'
of the type analyzed by Myers & Majluf [1984] when a firm makes a rights
offer in which current shareholders do not wish to participate and accordingly
sell their rights in the secondary market. However, shareholder takeup is in
part determined by factors such as personal wealth constraints and demand for
diversification which are beyond an issuer's control. These factors tend to limit
shareholder participation in equity issues by relatively large widely held firms.
Thus, it is possible that issuers which anticipate a low shareholder takeup turn
to underwriters for (imperfect) quality certification in order to avoid the high
adverse selection cost of the rights offer method in the face of heavy sales of
rights. The Eckbo & Masulis adverse selection framework also implies that firms
with less discretion over issue policy, such as regulated utilities, bear lower adverse
selection costs and so tend to use rights more often than unregulated firms, which
is supported by the empirical evidence.
Recent studies have also established that while IPOs are substantially under-
priced, SPO underpricing is negligible. This difference in underpricing accounts
for the finding that IPOs are on average substantially more expensive than under-
written SPOs for issues of similar sizes. Flotation costs as a percent of underwritten
SPOs' gross proceeds, consisting primarily of underwriter fees, decrease with issue
size and increase with stock risk and share-ownership dispersion. Overallotment
options, frequent in IPOs but less frequent in SPOs, typically account for a very
small percentage of the SPO's gross proceeds.
The results of the growing literature on the valuation effects of SPO announce-
ments, typically represented by the two-day announcement period abnormal stock
return, give further support to theories of adverse selection in primary markets
for securities. In particular, the announcement effect is nonpositive across both
equity and debt issues, and significantly negative for issues of equity and convert-
ible debt. Consistent with the adverse selection framework of Eckbo & Masulis
[1992], the market reaction to equity issues is most negative for firm commitment
offers, least negative (or zero) for uninsured rights, with standby offers in between.
The international evidence also typically indicates a negligible market reaction
to uninsured rights issues. Moreover, consistent with Krasker's [1986] extension
of the Myers & Majluf [1984] model, the valuation effect of firm commitment
equity offers is more negative the larger the relative issue size. Finally, equity
issues by regulated utilities, which have smaller adverse selection effects due to
the regulatory process, are consistently associated with smaller negative abnormal
returns than equity issues by industrial firms.
Adverse selection arguments can also be extended to analyse the timing of
SPOs. These arguments imply that the frequency of equity issues tends to rise
during economic expansions, and thus, the negative market reaction to the typical
issue tends to fall. Furthermore, equity issues are predicted to occur more
frequently after major information releases (e.g., of accounting earnings) and,
with the exception of uninsured rights offers, to follow significant runups in an

issuer's stock price. All of these predictions receive substantial empirical support.
Finally, seasoned public offers of common stock have important impacts on the
secondary market in which the common stock trades. The typical firm commitment
offer involves a large increase in shares outstanding along with a large increase
in the number of stockholders and a reduction in management and blockholder
percentage ownership. As a result, one would anticipate that there would be major
increases in trading volume, a lower percentage of insider trading and possibly
major changes in price volatility after the public offering.
The growing literature examining these effects finds that percentage bid-ask
spreads of common stocks having firm commitment SPOs drop significantly before
and after the public offering date. This post offer phenomenon in part reflects
the increase in shareholders and trading volume which occurs after the SPO.
Percentage bid-ask spreads of common stocks experiencing equity rights offers
increase before and during the rights offer period and decrease only slightly
thereafter. A firm issuing common stock through a rights offer can be viewed as
experiencing a stock split which tends to increase percentage spreads, while the
resulting increase in shareholders and trading volume is substantially less than
the changes which typically occur in firm commitments. Finally, the offering date
return exhibits a significant negative bias due to the preponderance of sell orders
received in the secondary market. This reflects the diversion of buy orders from
the secondary market to the primary market during the offer period.
Appendix. Summary of empirical observations on seasoned public offerings
1. Corporate funding sources.

(i) Internal equity has remained the dominant funding source for U.S. nonfinan-
cial corporations after the second world war.
(ii) Debt dominates equity as an external funding source, with net retirements of
equity in the 1980s.
(iii) In periods with low internally generated equity, the proportion of debt
financing tends to increase to finance the shortfall. In periods with high
internal equity, debt issues tend to be used to retire external equity.
2. Leverage ratios. Leverage (debt to total asset) ratios for U.S. manufacturing
companies have increased steadily over the post-wa r period from a low of 30% in
1946 to approximately 60% in 1984.
3. Offer frequencieS.
(i) The ratio of public equity to public debt issues tends to increase during
business cycle expansions and to decrease during business cycle contractions.
(ii) Until the second half of the 1980s, only a small fraction of security issue
volume in the U.S. was sold privately. However, recent years have seen a
substantial increase in private placement volume.
4. International funding sources.

(i) Retained earnings are the major source of finance in all the industrial
countries studied.
(ii) The proportion of external funding is largest in Finland, France, Japan and
Italy.
(iii) Banks are the dominant source of external finance in all countries, represent-
ing approximately 40% of gross sources in France, Italy and Japan.
(iv) Companies in Canada, France and Italy are the largest user of external capital
markets, with short-term securities, bonds and shares representing 19%, 13%
and 13% of gross financing, respectively.
(v) Canadian, French and Italian firms raise approximately 10% of their gross
financing by issuing equity, while the corresponding proportion is less than
5% in Germany, Japan and the U.S..
5. Volume of European SPOs. By 1987, the dollar volume of new security issues
made by European nonfinancial corporations had reached approximately three-
quarters of the corresponding issue volume in the U.S. and Japan. The 1987
total issue volume in European domestic markets was approximately four times
the combined volume in the Eurobond and Euroequity markets. European equity
issues by nonfinancial institutions had grown to more than twice the volume of
equity issues in the U.S. and in Japan.
6. SPO flotation method trends" in the US.

(i) Over the past 60 years, publicly traded U.S. companies have gradually
switched from the uninsured rights and standby flotation methods to the firm
commitment method. By 1980, the rights method has virtually disappeared in
the group of large publicly traded industrial firms.
(ii) U.S. firms also show an overwhelming preference for the firm commit-
ment method when offering securities other than common stock, including
mortgage bonds, straight bonds, convertible debt, convertible preferred and
warrants.
7. IPO flotation methods'. In the U.S., IPOs are sold almost exclusively by means
of the firm commitment method (approximately 60%) and the best efforts under-
written method (approximately 40%).
8. DRIPs" and ESOPs. There is evidence that DRIPs and ESOPs, which in many
ways are similar to periodic rights offers, to some extent have replaced rights
issues as a means of raising capital from shareholders and employees.
9. International flotation method trends. Domestic issues in the Canadian, the

European and most Pacific Rim capital markets are predominantly sold through
rights. There is a trend towards increased use of underwriters and the firm commit-
ment method in these markets as well. In Japan, one of the largest stock markets,
a majority of equity issues is now sold through the firm commitment method.
10. SPOflotation costs. The empirical evidence indicates that direct flotation costs
on average
(i) are higher for common stock offers than for debt offers of comparable size,
and higher for convertible debt than for non-convertible debt;
(ii) are higher for industrial issuers than for public utilities;
(iii) are lowest for uninsured rights and highest for firm commitments, with
standbys in between; and
(iv) are higher for negotiated than for competitive underwritten contracts.
11. Flotation costs and offer characteristics. The empirical evidence indicates that
di~rect flotation costs depend on issuer characteristics such as gross proceeds
(scale economies), stock risk (value of an underwriter guarantee), and shareholder
concentration (rights distribution costs). Direct flotation costs remain lowest for
uninsured rights and highest for firm commitments after controlling for these issue
characteristics.
12. Issue underpricing and overallotment options. Underpricing, while large in

IPOs, is negligible in firm commitment SPOs. Overallotment options, which are
common in firm commitment IPOs, are much +less frequent in SPOs, and the
average value of this option is a very small percent of the SPO's gross proceeds.
Overall, flotation costs as a percent of offering proceeds, and the risk of offer
failure, are substantially higher for IPOs than for SPOs.
13. Additional costs of rights. Additional shareholder-borne costs which tend to

reduce the attractiveness of rights arise from capital gains taxes, reduced stock
liquidity, transaction costs of selling rights, arbitrage activity which affects the
risk of offer failure, and anti-dilution clauses which induce wealth transfers to
convertible security holders.
14. Valuation effects of SPO announcements in the US. For NYSE/AMEX listed
firms, the average valuation effect (typically represented by the two-day announce-
ment period abnormal stock returns) is
(i) non-positive;
(ii) more negative the larger the size of the issue;
(iii) most negative for firm commitment offers, least negative (or zero) for
uninsured rights, with standby rights in between;
(iv) most negative for common stock, least negative (zero) for straight debt/
preferred stock, with convertible securities in between; and
(v) smaller for public utilities than for industrial issuers.
15. Valuation effects of SPO announcements internationally. Internationally, where

common stock is primarily issued using rights and standbys, the average market
reaction is either positive (Finland, Japan, Korea, Switzerland, UK) or small but
negative (Australia, Canada, Norway).
16. Valuation effects of other capital structure change announcements. For exchange
listed U.S. firms, the average valuation effect (typically represented by the two-day
announcement period abnormal stock return) is
(i) positive for private placements of common stock;
(ii) positive when debt/preferred stock is exchanged for common and negative
when common stock is exchanged for debt/preferred stock;
(iii) positive when common stock is repurchased (by tender offer/open market
repurchase);
(iv) negative for convertible debt/preferred stock calls forcing conversion into
common;
(v) positive for withdrawals or cancellations of common stock offerings; and
(vi) non-negative for adoptions of DRIPs and ESOPs.
17. Rights" vs. underwritten offers. In Eckbo & Masulis [1992], a rights issue where
current shareholders elect not to subscribe causes the market to infer that the firm
is of relatively low quality, resulting in relatively large adverse selection costs of
the type analyzed in Myers & Majluf [1984]. Current shareholder takeup reduces
adverse selection costs, as does costly quality certification by underwriters. In this
framework,
(i) expected shareholder takeup is an important determinant of the flotation
method choice;
(ii) firms selecting uninsured rights sometimes use shareholder subscription pre-
commitments to credibly signal a high shareholder takeup;
(iii) firms tend to switch to underwriting as the firm's ownership structure be-
comes dispersed (as with most publicly traded firms);
(iv) firms with less discretion over their issue policy, such as regulated utilities,
tend to use rights more often than unregulated firms; and
(v) the market reacts most negatively to firm commitment offers, least negatively
to uninsured rights, with the market reaction to standby offers in between.
All of these predictions are supported by empirical evidence.
18. Timing of equity issues. Several models predict that the frequency of equity
and debt offers will vary with the business cycle and with the prior stock price
history of the security issued. Several pieces of evidence support these predictions:
(i) the frequency of equity issues tends to rise during economic expansions;
(ii) the magnitude of the negative market reaction to firm commitment offers of
equity decreases in expansions;
(iii) equity issues occur more frequently after accounting earnings releases; and
(iv) on average, firm commitment issues of common stock occur after a significant
runup in the issuer's secondary market price, while no such runup is observed
prior to equity rights issues.
19. Effects of seasoned equity offers on bid-ask spreads. Percentage bid-ask spreads
of common stocks having firm commitment SPOs drop significantly before and
after the public offering date. This post offer phenomenon in part reflects the in-
c r e a s e in s h a r e h o l d e r s a n d t r a d i n g v o l u m e w h i c h occurs after t h e SPO. P e r c e n t a g e

b i d - a s k s p r e a d s o f c o m m o n stocks h a v i n g e q u i t y rights offers i n c r e a s e b e f o r e a n d
d u r i n g t h e rights offer p e r i o d a n d d e c r e a s e only slightly t h e r e a f t e r . A firm issuing
by m e a n s of a rights offer can b e v i e w e d as e x p e r i e n c i n g a stock split w h i c h t e n d s
to i n c r e a s e p e r c e n t a g e spreads, while the r e s u l t i n g i n c r e a s e in s h a r e h o l d e r s a n d
t r a d i n g v o l u m e is s u b s t a n t i a l l y less t h a n i n firm c o m m i t m e n t s . Also, t h e offering
d a t e r e t u r n exhibits a significant n e g a t i v e bias d u e to t h e p r e p o n d e r a n c e of sell
o r d e r s r e c e i v e d i n the s e c o n d a r y m a r k e t .
Acknowledgements
W e a p p r e c i a t e t h e c o m m e n t s o f the referee, R e x T h o m p s o n .
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Chapter 31 Seasoned Equity Offerings A Survey

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R. Jarrow et al., Eds.

, Handbooks in OR & MS, VoL 9

Seasoned Equity Offerings: A Survey

Corporate securities are issued through a wide variety of methods, often

2. Trends in aggregate corporate financing activity

2.1. Debt vs. equity

Corporations raise capital through internal sources of equity (retained earnings

S o u r c e s o f f u n d s f o r U.S. n o n f a r m , n o n f i n a n c i a l c o r p o r a t e business, 1946-1991 a

Leverage ratios for U.S. corporations, 1926-1986 ~

Year All U.S. corporations Manufacturing corporations

1926 - 0.21 - 0.09 -

1930 0.18 0.24 - 0.10

1940 0.33 0.26 0.57 0.11 0.27

1950 0.18 0.23 0.63 0.11 0.31

1960 0.18 0.27 0.66 0.17 0.38

Year All U.S. corporations Manufacturing corporations

p r o p o r t i o n of d e b t than equity issues. A firm issuing $100 w o r t h of equity to

O b s e r v a t i o n 1 Corporate funding sources,

Models of optimal capital structure predict that a number of economy wide

2.2. Public security offerings for cash

Observation 3 Offer frequencies.

2.3. International trends

Average financing of nonfinancial enterprises, in percent of total financing sources, 1970-1985 a

Canada b Finland c France Germany d Italy e Japan f United United

Retentions 54.2 42.1 44.1 55.2 38.5 33.7 72.0 66.9

Observation 4 International funding sources.

Observation 5 Volume of European SPOs. By 1987, the dollar volume of new

3. Flotation methods and costs

3.1. Frequency of major flotation methods

Panel A: Volume of domestic corporate security issues in 1987 ($ billion)

United States Europe Japan

Panel B: Security issues by European nonfinancial corporations, 1985-1987 ($ million) f

Nonfinancial debt issues Nonfinancial equity issues Total nonfinancial issues

active s e c o n d a r y m a r k e t w h e r e c u r r e n t prices for the stock are easily o b t a i n

Observation 6 SPO flotation method trends in the U.S.

Source: Eckbo and Masulis [1992] 6

Alternative methods of security issuance by type of security, U.S. 1977-1982 a

Initial registered offerings (IR)

Types of firm commitment underwriting arrangements

As documented by Eckbo & Masulis [1992], concurrent with the disappearance

Observation 8 DRIPs and ESOPs. There is evidence that D R I P s and ESOPs,

4 See Chang [1990] for a further description.

Observation 9 International flotation method trends. Domestic issues in the Cana-

3.2. Direct flotation costs

E q u i t y s e c u r i t y issues by firms listed o n the Tokyo Stock Exchange, 1956-1990 a

R i g h t s offerings P u b l i c offerings Private Exercise Total

1956 294 157 36 4 11 2 - - 341 164

a Source: T h e Tokyo S t o c k E x c h a n g e Fact Book, m u l t i p l e years• T h e t a b l e i n c l u d e s foreign issues•

negotiations but sometimes by competitive bids). Average firm commitment costs

Flotation costs Firm commitments Standby rights Uninsured rights

Number of observations 351 639 42 89 26 23

Const. PRO PRO 2 SCON ST A SHR D1 D2 R2 F value

L Firm commitments (N = 334)

Const. PRO PRO 2 SCON ST ASHR DI D2 R2 F value

L Firm commitments (N = 629)

Observation 11 Flotation costs and offer characteristics. The empirical evidence

It has become common for an issuer to grant the underwriter an overallotment

Observation 12 Issue underpricing and overallotment options. Underpricing, while

3.3. Additional costs of rights

Observation 13 Additional costs of rights. Additional shareholder-borne costs

There is currently insufficient empirical evidence to dismiss these additional

4. Valuation effects of SPO announcements

4.1. Summary of evidence