Financial Markets and Corporate Strategy Mark Grinblatt University of California at Los Angeles Sheridan Titman University of Texas—Austin Irwin/McGraw-Hill Boston, Massachusetts + Mauison, Wisconsin St.Louis, Missouri ‘+ New York, New York Burr Ridge, Illinois + Dubuque, Iowa + San Francisco, CaliforniaTomy dear brother Arnie, for his courage, prseverence, and inspiration MG. ‘Tomy fanily, for their nduring love and support. ST. Irwin/McGraw-Hill A Din of Te Mira Capone FINANCIAL MARKETS AND CORPORATE STRATEGY Copyright © 1998 bythe MeGraw ill Companies, ac Alright reserved. Pit athe Unie Stes of Aneica Eicept a permited user te Unted Stes Capit Act 1976, so part ol ths ableton maybe epoced or dred in an or aby ty an, sb {1dn bas or fea atm tout the ioe ween persion a he poie ‘his book i printed nai fee pape 3457890 VHVHOO98 itor rector: Michael W, Jno Publisher: Gary Burke Sponsoring eto: Gina. Hk Marketing manager: Ratle Mow Mathews Secor peer manage: foe Low Hes Prado snervio rt Kotor, Designer Marie Balan Kier Consophan Compost Sepa Poorman Conmuniarons Typeface: 10172 Times Rema Ptr oe ofan Pres Pc Library of Congress Catalagng in Publiation Data rib, Mak sii arcs ancora rey Mark bi, Po (The liyMeGrav-Hllseics in fancs, ineurtnee, and elevate) [rFinaciistions—Unied Sites. 2. Coporaticns United Ssaes—Finace 3. Siege plaing—United Sates. 1 Tima, Sodan "IL Tie IL Svs: eviacGraw il sere in (815-421 seas InipaereiecomCHAPTER, 18 ox The Information Conveyed by Financial Decisions Learning Objectives Ate reading this chapter you should be able to: 1. Understand how financial decisions are affected by managers who are better informed than outside shareholders about firm values, 2. Identify situations in which managers have an incentive to distort accounting information, ‘3. Explain how financial decisions sbout the firs dividend choice, capital structure, and real investments affect stock prices 4. Interpret the empirical evidence about the reaction of stock prices to various financing and investing decisions. (On July 10, 1984, TT announced a 64 percent cut in its quarterly dividend from $0.69 10 80.25 per share. Rand Araskog, CEO of ITT, said that the directors approved the dividend eu 10 save $232 million, enabling the firm to continue to fund its ivestment In igh technology products and services. The market greeted this announcement with 1132 percent price drop in ITT stock from $31 to S2Ukper share, implying a reduction in sharcholder value of about $1 billion Yhe magnitude ofthe decline in IT's stock price, described inthe chapters opening vignette, is certzinly unusual. However, stock prices often move 10 to 15 percent \when firms announce changes in their investment, dividend, or financing choices, imply ing that decisions like these convey information to investors which cause them {0 1€~ evaluate, and thus revalue, the frm. ‘ee Worége and Ghos (945) or more dsuson on thi pry ceChaper 18. The tfomation Conese hy Financial Deciins os This chapter provides a framework that wil help you to decipher the messages ‘conveyed by financial decisions and to understand how information considerations affect financial decisions. The discussion in this chapter i based on the premise that top ‘managers have proprietary information tha enables them to derive more accurate inter nal valuations of theit companies than the investor valuations determined inthe market, In other words, managers may have information, which eannot be dieetly disclosed, aout whether the firm's stock i either undervalued or overvalued, Managers may not be able to disclose their information tothe firms stockholders for a variety of reasons: + The information may be valusble to the firms competitors, + Firms run the risk of being sued by investors if they make forecasts that later turn fat to be inaccurate ‘Managers may prefer not to disclose unfavorable information + The information may be dificult to quantify or substantiate, If direct disclosures provide imperfect and incomplete information, then investors ‘will incorporate indirect evidence into their evaluations. In particula, investors will atiempt to decipher the information content of observable management decisions. These information-revealing decisions, or signals, might inlude decisions related tothe firms capital expencitures, financing choices, dividends, stock splits, and management share holdings. For example, an increase in company shareholdings by IBM's top executives ‘might signal that managemeat is optimistic about the firms prospects. In many instances, {an indirect signal ofthis type can provide more eredible information than a direct diselo~ sue, As itis often suid. “Actions speak loner than words" ‘ismatural to assume that managers take the market's expected reaction into account when making major decisions. This is especially true when the ability of managers to keep their jobs, maintain their autonomy, and increase their pay depends, in part on the performance oftheir firms stock, If managers have a strong incentive to increase the current stock prices of their firms, they will bias their decisions towed actions that feveal the mos favorable information to investors. As we will demonstrate, these actions will not, in general, maximize the intinsie or long tern vl of the frm. [nother words, ‘managers may sometimes make value reducing decisions because they convey favorable information, ‘An important lesson of this chapter is that a distinction must be made between ‘management decisions that create value and decisions that simply signal favorable infor- ‘mation to shareholders. In many cass, value-creating decisions signal unfavorable infor ‘mation and result in tock price declines, and value-destroying decisions signal favorable information and result in stock price increases. For example, IT's decision to cut its dividend would be considered value creating ifthe cash savings were used for positive net present valuc investments. However, as this chapier discusses, the dividend cut might signal unfavorable information about the Firms ability to generate cash from its existing operations. had decisions sometimes convey favorable information, one must be careful when imerpreting stock price reactions to corporate announcements. For example, a company might think that its shareholders prefer higher dividends because is stock price always reaetsfevorably when a dividend inerease is announced. However, as shown later in the chapter, stock prices can respond favorably (oa dividend increase because the increase ‘conveys favorable information, even wien most shareholders actualy prefer the lower dividend.on 18.1. Manaj than Sharel fs Por Incomes, xformaron.ond Corporate Control ement Incentives When Managers Have Better Information jolders “Most of the discussion in this text assumes that managers act to maximize their firm's share price. However, if there isa difference between what managers believe their firm's shares are worth and the market price of those shares, then the appropriate goal of the managers needs further elaboration. Should managers act to maimize the current mr- ket price ofthe firms share, which reflects only public infarmation, or should they act to maximize what they belcwe isthe firms longterm expected value, which reflects the managers’ private information? In some cases, there is no conflict tween these two abjctives, even when there is a difference between the firms long-term expected valie, which we refer to a8 the intrinsic value, and its current market value. However, as shown Inter in this chapter ‘when a decision comeys information that analysts use to value a fies stk, decisions that maximize the frmis stock price may not be in the best long-term interests of share holders. When this isthe case, differont sharcholdors will not necessarily agree on how ‘managers should choose between these conflicting objectives, Shareholders who plan to hold onto their shares fora Tong time prefer managers to ‘make decisions that maximize the expected value of the shares atte Future date when these shareholders plan to sell. This of course assumes that managers correctly assess the firms intrinsic value and are not, for example, overly optimistic. However, share holders who plan to sell their shares in the near future prefet managers to take actions that improve the firm's current share price irespective of how this affects the firm's intrinsic or long-run value. Thus, there is an inherent conflict between the interests of long-term and short-term shareholders. Conflicts between Short-Term and Long-Term Share Price Maximization Exhibit 18.1 illustrates that managers have a number of competing pressures that deter- mine how a firm's current share price and its intrinsi value enter the decision criteria, IF aL manager expects to be a long-term player atthe firm and intends to continue to hold stock and options in the firm, then he or she is likely to want to maximize the firms intrinsic value. However, most managers also are concerned about the firms current stock. Price. The concern fr current stock prices can arse for several reasons + Managers may plan to issue additional equity o sell some oftheir own stock in the near future + Managers may be concerned about the acquisition ofthe firm by price that is less than the fiw intrinsie valu. + Managerial compensation may be directly or indirectly ted to the current stock price ofthe firm. + The ability to attract customers and other outside stakeholders may be related to ‘outsiders” perceptions ofthe firm’ value. wn outsider at a Although managers usually have an incentive 10 inerease the firms current stock price, the degree to which they are willing to sacrifice intrinsic value varies. Indeed, ‘managers also might want to temporarily lower the current stock price of their firms, we illustrate in the next section, Given these inevitable conflicting incentives, we might best view a manager's objecProssure frm ‘Shortie stoners Chopter 18 The afiemation Comeyed hy Finacial Decisions 63s som about Pressure rom | tonearm socials Result 18 tive tunction 8 one of maximizing a weighted average ofthe firm's current stock price ‘and incinsic value, as shown below: wcSe+ mS Where we and w, are the weights given by management tothe importance of Se and S, the firmis current and intrinsic values ofits stock, respectively Management incentives are inueaced bya deste to increase the frm curren share pice and its intrinsie value. The weight hat manager plac on these potentially contiligineen tives is determined by among othe hing, the manager’ compenstlon dn the security of ‘he manager's job. Example 18.1 illustrates how the we determined. iahts on current and intinsic value are Example 18.1: ‘The Trade-Off between Current Value and Intrinsic Value John Janes, CEO of Temont Corporation, has ust exercised 10,000 stock options and now ‘owns 20,000 shares of Tremont stack. He plans on sling tho 10,000 shares within the nxt ‘month and wil hold the remaining 10,000 shares inatintaty. Resa that hie salar eno, ‘describe how Janes’ objective function would weight current alum anc inns value “Answer: Jones ould weight curent value and itrnsic value equally In other words, he \would be wing to make a decision that reduces Ttemant'slong-erm or iinsie stock pice bySt per sharefincreaseaits current stock price by more than $1 per shave, ‘The Joint Venture of IBM, Motorola, and Apple Computer ‘The Joint venture between IBM, Motorola, and. Apple Computer to collaborate on new Personal computers and workstations (ihe power PC chip) provides sn example of haw636 ‘art comin lifvmarion, and Corporat Cool corporate dcisous can provide information that is potentially relevant fr pricing firs Sock. On the announcement of such a venture, analysts and investors arempt 10 assess Siete the joint venture isa good decision and whether i wll be sucessfl- Fer example, Tt they beliee the decison is good for TBM, there willbe upward pressure oa the price of IBM stock, On the her hand if they believe tsa bad decision, there wll be dosaward pressure onthe pce of TBM stock. In adion, the market resction to the announcement ‘illest ew information abot IBM that signaled indirectly the amovncemen. "This new information may have alaicst noting to do with the mess ofthe particular transaction, For example, the joint ventore could have been viewed as a favorable signal sthout IBM future prospects because it shows that IBM is confident sbout is abit to fund ‘riajor new investment Alternatively, sch an investment might be viewed as @ negative Signal f the analysts interpretation is that TEM has unfavorable prospects inthe mainframe business andthe company isnt confident abou is ability t0 develop new personal eomput- fs and worktatons on its own. If this negative information is suficeily important then TBM stock price will crop onthe announcement ofthe oi venture even ifthe venture is believed in br a good decision 'TBM's tnanagers are thus faced witha derma in making sucha choice f [BM man- agers are concerned shout the fi curtet share price and they anticipate an unfavorable sock ce eat, hen ey may Shon opus up ja vente on she pos Result 182 Goa decisions can reveal unfivorble information and bad decisions can reveal Favorable Information, This means tht: + Stock price actions ate sometimes poor indictors of whether a decision has Positive ora nepative effect ona firms intinsic value + Managers who are concerned about he current share prices oftheir firms may bis their decisions in ways that educe the intrinsie values of thelr fms 18.2. Earnings Manipulation “The focus of the chapter is on how information considerations affect financing. and investing choices. However, itis insinictive to look first at how these considerations affect the earnings reported by firms. Recent accounting research suggests that managers sometimes manipulate the earn ings numbers of their frm in ways that increase reported income in the current year at the expense of reporting lower earnings in the future. Managers have some discretion ‘over the firms accounting methads, which allows them to shift reported income from the future t0 the current year and vice versa. For example, if the firm elects to use straight-line deprecation, reported earnings are initially higher since the intial deprec tion expenses are lower than they would be with accelerated depreciation. However, the ‘opposite is true i later years: Accelerated depreciation methods cause reported earnings inthe liter years to be higher than they would be with straight-line depreciation. Simi larly, the choice of inventory valuation methods—that is, LIFO (last in, first out) or FIFO (first in, first out)—affects current and future earnings, depending om whether input prices are rising or falling ‘These accounting methods are typically disclosed in a company’s public financial statements, However, other undisclosed accounting decisions also affect earnings. For txample, managers have discretion in coming up with a number of estimates, including the service lives and salvage valves of depreciable assets, the lives of intangibles, the luncollectible rate on accounts receivable, the cos of warranty plans, the dezree of com: pletion when the percentage-of-completion method is used for certain assets, the actuChaser 18. The information Conve by nail Decisions or arial cost basis fora pension plan, and the interest rates fr capitalized leases and pension accounting. As illustrated below, accounting changes can have dramatic effects on re ported earnings. ‘The Management of Reported Earnings by General Motors 10985 and 1989, General Motors reported slg isingearnings despite the decline ints cr end rock sles. Although the efforts of General Motors to stcamline ts operations ‘may have coteboted to this earnings increase, acouating changes ls effete i repertod caring. In 1986, General Motors raised the expected rt of return on its existing pension sits ‘which elloved it to reduce the amount hat # was rouited to ald to the fund inthe current and subsequent years. This iacreaed reported protein 1986 by about S198 milion, I 1987, General Motors increased the estimated wef life of is plant and expen which reduced deprecation and amortization charges in that year, thersby increasing ts reported earnings by about $1.2 bili, Incentives to Increase or Decrease Accounting Earnings Firms show the greatest tendency to artificially inflate accounting earnings whien ma agers have the most to gain from inereasing share prices. For example, Teoh, Welch, and ‘Wong (1997a, 1997b) found that firms make discretionary accounting choices that tem pporarily increase reported earnings prior to both initial and seasoned public offerings of {equity In these cases, managers are especially intrested in improving the firms current stock prize because they want fo maximize the proceeds from the equity issues, Occasionally, managers also manipulate their earnings downward when they want their firms 1 appear weaker than they ealy are, For example, Liberty and Zimmerman (1986) found that some firms manipulated their earnings downward prior to union ne _otiations, and Jones (1991) found strong evidence of managers manipulating their com: pany’s earnings downward prior to appealing to the goverament fr help agains! foreign competitors 18.3 Shortsighted Investment Choices. Savvy investors and analysis, understanding the incentives of firms to manipulate their feanings numbers, are generally reluctant to take the reported earnings numbers face value. Some analysts have a preference for evaluating firms based on cash flow rather than earnings numbers, which are less subject to aecounting manipulation. However. firms also make real investment and operating decisions that affect the cash low num bers, as well as earnings, and managers may be motivated to bias these decisions in ways ‘that make the firm look better in the short run but which hus te firm inthe long rn ‘Management's Reluctance to Undertake Long-Term Investments ‘A numberof financial economists have argued tht th incentive of managers increase current share prices makes managers reluctant to take on long-term investaent projects that generate low initial eash flows. The reluctance to tke on long-term projec arises “This xumpl taxed on he discasion in Lowi Lowes, Sense and Non Sense in Corporate Fingace eating, MA: AdduenWesey. 191 “hangers incesve to be shorisiatedin making imestent chess analyzed ia Sen (1989), Narayan (1989), an Brean 990),638 Result 183 Part laentives. femation.and Corporate Conrod because investors understand that managers have an incentive to falsely claim that their investment projects have substantial payoffs several years down the road. However, ‘estors have no way of Knowing ovkether the managers are telling the truth about Future ‘payoffs or whether they are simply making long-term promises o coverup their current poor performance. Asa result, the market price of a firm's stock tends to react negatively fo poor performance in the current period, generally ignoring management claims of big payolts in the future. While this is aot a problem for managers who are inetested only inthe intrinsic value of thei shares, it creates problems for other managers who have incentives to keep their current share prices high. This problem is ilustrsted in Example 18.2 Example 18.2: The Incentive to Choose Projects that Pay O1f More Quickly Mice Industries has avaiable two long-term investment strategies anda shor-erm stalogy ‘Te cash flows ard ther present values are described below, ‘cash Flows in mil oars 2-10, Year! fannuateaoh few) Value at Yoar 1 1. Goodiongtemetatagy $40 se0 3600 2 Shortie siatogy 0 0 ‘400 & Badiongterm strategy «0 * 300 Miro induction le not coneidoring the thir etratgy, Docauee te prazent value of $300 milion is coviusly an interior choice. Tha thd strategy crest a problem for Miro, however, be ‘ue Investor ate wera ofthis tategy, but are exoptealabout whether Micro can generate ‘tho lend of roturne reflected in ttatagies 1 and 2 desoibed above. As a rosul, if the good long-term atratagy le selected, Micros year 1 markt price wil be ely $300 milion, reflecting the markat's babet that the cash flows ofthe thie strategy wll be reaizod. However, the ‘market pice wil sa to S800 mulion the folowing yaar wen the fist annual cash flow of ‘$80 milion is observed. Ifthe short-term strategy i selected. investors il ealze is potential “ner tne year feash flow of S60 millon s observed and they villvaive the rm at $400 milion, Which project should management salt? "Answer: I management fs conearned only with maximizing the fms intrinsic val, it ‘snout! select the good long-term statoay. However, if managers place sufficient weght on having a high stock pice year 1, they shoul take the shork-term strategy because the year ‘Tmarket pies in yar twil fhen Be $400 milion rather than $300 millon. In Example 18.2, management may be reluctant to select the superior long-term strategy because the initial eas lows lead investors to believe thatthe company's future profits wil be much lower than they wil be in reality. However, by choosing the lower~ ‘valued short-term strategy investors immediately recognize the fits ability to generate better than expected cash flows and thus reward it by immediately boosting its stock ‘mice. The insights of this example are summarized inthe following result “Managers wil select projects that pay off quickly over posibly higher NPV projects that pay autower longer periods if they pace significant wiht on increasing thee frmscurrent pereeisChapter 18 The normation Coneyetby Financial Decisions 9 What Determines a Manager's Incentive to Be Shortsighted? ‘The tendency of managers to implement strategies with hetter long-term payollsin- creases as the weight that managers place on maximizing the current or near-term stock price declines. To understand this, consider again Example 18.2 and assume thet mas ‘agement places a 75 percent weight on the year 1 value of the firm and a 25 percent ‘weight on its intrinsic valu, implying thatthe weighted average payott from the long- term strategy (.75 % $300 million + .25 % $600 million) is $375 millon, which is less than the $400 million payoff from picking the short-term strategy. However if manage ‘ment weights intrinsic value and current share prices equally, then the long-term strategy will be selected because the weighted average value from the strategy is $450 million (3. $300 million + 5 $600 million), which exceeds the value ofthe short-term strategy. ‘A number of policymakers and journalists have argued thatthe incentive to be shortsighted, as Example 18.7 illustrate, applies more to US, managers than to Japanese ‘managers because the former place greater weight onthe current share prices oftheir firms. The basic argument for this tendency is that US. managers are moritered more closely by institutional investors, are more subject to takeover threis, and have a larger Part oftheir compensation ted tothe short-etm performance oftheir firms. The prod- lem is compounded by the tendency of Americans to change jobs more often than the Japanese. Some writers have claimed that these factors have tended 0 make US. fis Jess wiling to make long-term investments that ensure their long-term competitiveness! ‘18.4 The Information Content of Dividend and Share Repurchase Announcements ‘This section examines the information conveyed by dividend and share repurchase an- ‘nouncements. As this chapter’ opening vignette lustrats, dividend changes can lead to «dramatic changes in stock prices Empirical Evidence on Stock Returns atthe Time of Dividend Announcements Rest 184 When ficms announce dividend increases, their stock prices generally increase about 2 percent [see Aharony and Swary (1980)], Announcements of the initiation of quarterly dividend payouts by firms that previously paid no dividends generate even larger stock price reactions [see Asquith and Mullins (1983), Healy snd Palepu (1988), and Michael. Thaler, and Womack (1995). Meceever, took prices generally experience similar lines whea firms announce dividend decreases or omissions, falling about 9.5 percent, ‘om average, at the announcement ofan omission (Healy and Palepu (1988)] Stok prices increase, on average, when Hrs increase dividends and decease, on average when they decrease dividend, ‘As a corporate executive, you might interpreta postive stock price esetion to an announced dividend increase as evidence that investors consider the dividend increas to be good decision. This evidence, however, does not necessarily imply that dividend! increases improve the intrinsic value of firms. Financial decisions that convey favorable {information to the market tend to inerease stock prices even when the decisions are bad "Rapa (1994 proves veces ds wth ibs bel He pgs hat Japanese managers sts maybe stony otvated to improve the set term prfrmans of thers tey managePart tacemies, formation. and Coporate Comet for the frmis future profitability As shown below, dividend increases can destroy intin sic values, but they ean stil result in positive stock price responses because they signal avorable information A Dividend Signaling Model ‘Although there hase been a number of signaling-based explanations for, the positive “stock price response to dividend increases, we wll describe only one model * This model ‘which we belie is the most intuitive, is based onthe eas flow sourees and uses equality [see equation (14.1)in Chapter 14 ‘Aftertax new —_change in , interest _changein 4 gividends ash flow 7 investmeat debt” payments equiy * “¥en Information Observed by Investors. The following argument assumes that investors ‘cannot observe tre cash flow (or earnings) because managers can manipulate accounting rhumbers in ways that investors may not beable to unravel. In addition, items such as the firms investment in equipment maintenance or expenditures co update its customer da tabase are not disclosed and generally cannot be observed by outsiders. ‘Although investors cannot observe how much the firm actually invests, assume that they do know how much the firm should invest to maximize value. For example, analysts ‘may know that firm like Tohason Trucking should spend $10 million on maintaining feet of trucks even though the company’s actual investment in maintenance is nobser¥- able, Investors ight, therefore, be fooled if Johnson Trucking increases its reported cearnings artificially in a piven year by cutting back its maintenance expenditures from $10 million to $8 ailion. “The Information Content ofa Dividend Change. Consider acase where the manager has incentive to increase the firs current share price and, in contrastto our argument sibove assume tat analysts correcly infer that the manager chooses the optimal level of {Investment In this ease, the cash flows can be observed indirectly from the changes in the levels of debt and equity financing, interest payments, dividends, and the inferred level of investment. As Example 18.3 illustrates, an increase in dividends, withthe level ‘of investment and financing held constant, would imply an equivalent increase in eash flow and, hence, an increase in the firms value Example 18.3: The Information Content of Dividend Payouts ‘analysts observe that Johnson Trucking, an all equity firm, Nas not issued or repurchased ‘hares over the past year. They algo have observed that Johnson has paid out §10 min in BV with dividend increases, 2. Firms with MV > BV with dividend decreases 3. Firms with MV < BV with dividend increase, 4, Firms with MV < BV wih dividend decreases. ‘As Exhibit 18.2 shows, a dividend increase created only a slight stock price increase for firms belicved to have favorable investment opportunities (.e..MV > BV), Likewise, ‘dividend decrease generated only a slight stock price decrease, In contrast, dividend ‘increases and decreases resulted in much larger stock price responses for firms believed to have unfavorable investment opportunities (ie, MV < BV), This evidence suggests ‘that dividend changes are viewed as signals ofthe firms level of Future investment. Denis, Denis, and Sarin (1994) provide an alternative interpretation ofthe observed lfferences in the stack price reaction of high and low MVIBV Grms to dividend changes, ‘They pointed out that high MV/BV firms generally have lower dividend yields and {greater growth potential, which implies two things: 1. Increases in the dividends of high MV/BY firms are less likely to be viewed as a sumprise. 2, High MV/BV firms are likely to attract investors who are less interested in dividends “To understand tne mrst point, recall equation (10:5b) from Chapter 10. This equation, ‘based on the dividend discount model, states thatthe cost of capital is the sum of (1) the dividend yield and 2) the dividend grow rate, Hence, holding the risk ofthe firm (and ‘thus the cost of capital constant, low dividend yields imply high dividend growth rates fad vice versa, The second point isan implication of dividend clentles, discussed in Chapter 14. Both of these factors suggest that high MVIBV firms will react less t0 dividend increases than low MV/BV firms even inthe absence ofthe incentive problems discussed by Lang and Litzenberger. Denis, Denis, and Sarin demonstrate that after accounting for differences indivi ‘dend yields and the size ofthe dividend change, high and low MV/BV firms react simi larly to dividend changes. In addition, they found that following dividend increases, stock ‘market analysts increase their earnings forecasts more for low MV/BV firms than for EXnIprr 182 Average Daily Returns on Dividend Announcement Days, 1979-84 Difference iy Absa Divident Dividend Vitus or incre increase Decrease md Decrease weav 000% “0.008 ‘0000 wav 008 “oom 019" Ditercace 0.005" ome ois" mie Lae tLe (99.646 ‘rt Icemives tnormaton. and Corprte Con! high MViBY firms. Based on this evidence, they concluded that stock prices respond 10 dividend changes because ofthe information the announcements convey about the firms future earnings. Their evidence docs not support the idea that stock prices respond. because dividend changes provide information about the firms’ future investment choices, Dividends Attract Attention An ackltional possiblity is that a firm's dividend increase or initiation results ina stock Dice increase simply because it attracts atention tothe firm. To understand why inves tors generally view decisions that attract attention as good news, one must consider the ‘conditions under which the managers of firm would put the firm under greater scrutiny the firm is undervalued, increased Scrutiny is likely to lead to a positive adjustment in the firms stack pric, but if the firm is overvalued, the increased scrutiny is likely to lead toa negative adjustment in the firm's stock price. Hence, the incentive to attract attention {is greatest for those firms that ae the most undervalued, which suggests that one might ‘expect to s2e positive stock price reactions to any announcements that attract consider able attention. "The positive stock price reactions observed atthe time siock dividends and stock splits are announced support the idea that stock prices respond to announcements of managerial decisions that do no more than attract attention to the firm.” Unlike cash dividends, stock dividends and splits affect neither the firm's cash flows nor its invest. ‘ment alternatives. Yet, observed stock reuens atthe time of stock dividend and stock Split announcements are of approximately the same magnitude as the returns atthe time sncreases in cash dividends are announced. 18.5 The Information Content of the Debt-Equity Ch ‘This section examines the type of information conveyed to investors by a firms debt- ‘cquity choice, ‘The section discusses two reasons why the debt-equty choice conveys information to investors, First, because of financial distress cos, managers wil avoid increasing a firm's leverage ratio if they have information indicating that the firm could have fuiure financial difficulties, Hence, a debt issue can be viewed as a signal that ‘managers are confident about the firm's ability to repay the debt, The second reason has todo with the reluctance of managers to issue what they believe are underpried shares. Hence, an equity issue might be viewed as a signal that the lems shares are not under pried and therefore may be overpriced. A Signaling Modet Based on the Tax GainiFinancial Distress Cost Trade-Off ‘To understand why the debt-equity choice conveys information, assume, asa first ap proximation, that firms select their capital structores by trading off the tax benefits of Sebt financing (see Chapter 13) against the various costs of financial distress (@ee Chap ters 15 and 16). In this setting irms desire higher debt levels when expected cash ows “Grn, Masuli, 94 Ta (194), who proposed this “ation med prvidedesienc hat suck tris ard the time of tock vend wd stock pit announcements rea proximal the Snead aw stock sere rod th ie iden increase Fo further dstssion a irc lating oth potest, ee Hrennan and Hughes (1991.Result 188 Result 189 COhyper 18 The nfrmation Consevedby Finance Decisions or ate higher because they can better utilize the tax benefits of debt. In addition, for any ziven debt level, the probability of incurring the costs of financial distress is lower if expected cash ows are higher Because expected future cash flows determine the firms optimal capital stracture, the capital structure choice is likely to convey information to Shazeholders, While the information content of the capital stuctue decision would not affect the decisions of managers concerned only with intrinsic valu, it would affect the decisions of managers Who also are concerned about the current share prices of their firms. Indeed, managers whose objectives are heavily weighted toward the maximization of current share price are likely to avoid reducing leverage even when doing so improves the intrinsic value of ther shares. They may similarly choose to increase leverage beyond the point that max- imizes intrinsic vahue* ‘An increas in a frm’ debt ratio i considered favorable signal because tinct that ‘managers belive the firm wil be generating taxable earnings inthe future end tha hey are not overly concerned about incurring financial dsess costs. Manages understand that hei firms stock price sHikely to espond favorably thigherIverage ratios and ray thus have 1m incetive to select higher leverage ratios than they would ther wise prefer CCUC International Rorrows to Paya Special Dividend? Jn March 1999, CUC Internationa’ board of directors rife a leveraged recapitalization plan, that imvalved the payout of a special dividend of $5 per share, financed in ptt by = lean from GE: Capital. The total size of the dividend payment ($100 million) spresented ‘over half of the market vale of CU's equity prior tothe announcement. Waller Forbes, {he company's chairman ane CEO, mite tat part of the motivation forthe ecaptlien tom was the favorable signal of an increased debt rato, Fore ‘We judged thar borrowing @ mexerate amount ot debt to fnaNce the special dividend ‘vd add an propriate amount of leverage to our capital struct a wel as proving, ‘through the repayment ofthe det, «clea signal of CUC's ability to generate es, Wis clear that one of CUC Intemational’s motivations for increasing it debt ratio ‘was to senda signal to investors. However, an investor may question whether such @ signa is credible given thet the motivation for the debt increase was to boost the firms stock price. The following result describes conditions under which «financial signal conveys favorable information credibly For financial decision o credibly convey favorable infermaton to investors, ims with oor prospects must find it costly to mimic the decisions made by fins with favorable Prospect. ‘The Credibility ofthe Debt-Equity Signal. As Example 186 illustrates, issuing debt satisfies the requirement fr a credible signal, a specified in Result 18 9, because add tional debt is likely to have a much greater effect on the probability of bankruptcy for firms: with unfavorable fature prospects than tis for firms with favorable prospects Example 18.6: The Information Content of Leverage Changes ‘Analysts folowing Prarie Technologes are uncertain about Prarie success In reducing its (Production costs. thas been successful, Prat fulue earnings ae expected to range "Rs (1977 developed teary of apa uracore lang thse es “rms case tml sed on Pal Healy and Krsna Psp, "Using Coil Satie to Communicate antes Te Case of CUCItratonl,” Journal of pled Corporate Finance (Wiser 199), pesos68 Port Incentives. tema. and Corporate Corot Irom 359 ition te $60 millon, However, the company has not eon aveceeatl ts aain- Inge willbe inthe range of $25 milion to $30 milion. Praia announces a dabt for equity swap thet incresses ts Interest payments by $40 millon. What information is conveyed by this decision? ‘anewet: Anayeta can infor that tho cost reductions havo been successful. Otherwisa, fuen an ineoaee in lvorago would expose tho Tm to substantial bankruptcy risk and tho Aeeociatod trancial dlsvrecs costs. Hence, the markel responds to the announcement by Didsing up Pras stock price. Sines the fim Is eartain fo ava the cashflow fo mest esd interest payments, the sighal dd not reduce Praviatslong term value. Example 18.6 illustrates the situation in which a firm with favorable prospects sig- nals its vale by increasing its level of debt financing without risking bankrupte. In more realistic cates, a irm that wishes to signa its value wil ave to take on much more debt ‘than it etherwise would have found optimal ‘Consider, for example, a firm whose managers have strong incentives to increase ‘current stock prices and would be willing o take on a high deb level to achieve this goal ‘As aresult, outside investors will not find moderately high leverage ratios to be credible signals of high values. Hence, ifthe firm does have favorable prospects, it will have to tise much more debt financing than t would otherwise use in order t convince investors ofits higher value, We lustrate this concept in Example 187. Example 187: CHO Incentives and the Credibility of Financial Signals Textron CEO kaos thatthe fems assets are worth either $500 mien, $400 milion, or {£800 min, dapancing on the demand for thei product (each possibilty is equally Tks!) ‘Since manager information wil ultimately bereveaied, the average ofthese three numbers, ‘or $400 maton, isthe fms nin value, Howaver investors are notes optimistic about the fiers futur earnings a8 the CEO and beleve tha: the frm will have respective valves of '5450 millon, §350 millon. or $250 millon inthe three product demand scenarios qven above, implying tha he fis cutent value is $350 milen (assuming ro tnancial ditross costs The 350 millon discrepancy between the fim ininsc value and is current value presents ‘problem because Taxon CEO plans on seling large block of stock inthe noar future. AS ' consequence, before saling the stock, the CEO would keto signal o investors thal Tex trons value s $60 millon higher than investors currently belive tis. “The CEO has announced his bells about Textron prospects and investors know that the ‘ony alloratie to their own belils Is the moro optimise bolts of the CEO. However, the mere announcement of more optimistic bole e nota very credible signal to investors. They krow the CEO would be delighted to witness a temporary incoase in Textron's stock price before unloacig his block of shares, ‘Assume that the CEO has announces his intention to soll hal of his shares ano thus weights inrnee value and current valve equaly. Also assume tht nancial dsirass costs ‘ede he value ofthe fim by $60 rllonin whichever product demand soenariosuen distress ‘oours. The CEO has concluded that he may be able to credibly signal the more optimistic prospects by iesuing sulfcient debt and using the proceeds 1 aie equly. Fom the CEOS, Perspective, the Issuance of det with a promised payment in excess of $400 milion i pre ‘Cluded. There no need 10 risk fnarcial stress that reduces nile value by more than ‘one gas in current value (et of financial dstress cost). Moreover, debt narcing with & promised payment of less than $250 millon would not bea very edie signal in that—using ther investor beits or the more eplimistc CEO bellls—fhanca disse never occurs, ‘Analyze what hapbor to investor bel ifthe CEO issues debt (and reites an equivalent ‘amount of oauly) wih a promised payment (1) between $250 millon and $950 millon or {@} between $350 milton and £400 mon.CChaper 18 The Ifrmation Comesedby Financia Decisions a9 “Answer: 1) Debt issuance between $250 milion and $350 milion is not a cedibe signal to Inveatos that the higher fim valves wil be resized. Since Tentrorte CEO weights Current and intrinsic values of Tenren equal, he woul bo willng to take onthe amount cf Gets i doing 2 woul elgnal th highorvaluo, even Iti signal were false. To aee this, note ‘hat the CEO gains $50 milion in cunt markot value and loese only 620 milion {$60 milion a invinsic value frm Boing francialyastrassed in to lowest product demand ‘seenario. Inveetor, aware of the incetve tobe tnexed by 2 CEO who seas cath flow a2 esimistically as they da wil ot boleve that a debt signal of his magntuse Is cree (@) A debt coigaion between $350 milion and $400 milion would pa he fm in nara cistress of the time investor bails are caret bu oly 3 ol he tre i the more optimistic announced belies of the CEO were tru. No CEO with pessimistic bails would take on this, ‘much deb since. even investor belies change to thoso announced by the GEO. the gain in Current valuo (net of fnarcial distress cost) is $30 millon ($50 mien less} of $60 milion), ‘while the loss in intrinsic value to the deceptive manager 's $40 milion Goto ‘mition). By contrast, the loss in ninsc valu toa manager who rly hold optimisticbelis is $20 milion {€ of $80 milion). Thus, he signal of debts creibio inthis case bacause managors with plinstc balets na it profiabe to issue debi in amounts between $350 millon and {$400 millon atthe same time that managers with pessimistic bolls tnd it unprofitable to ‘signal by mimicking the same action. ‘The amount of debt financing firm must use to credibly signal ahigh value depends ‘on its manager's incentive to increase the firms current stock price, To understane! this, consider two CEOs, Jane and Janet. ane, who plans to retire soon and sll her holdings ‘ot er fms stock, has a strong incentive to temporarily increase her firms stock price, Janet, on the other hand, plans to stay on as CEO for 10 years at her firm. She also is Interested it buusting ce Giu’s vurcot share price, bu sie fs unas none conercd bout the firms long-term success and, in addition, i wortied about losing her job ithe firm has trouble meeting future interest payments. ‘The interpretation of the signal offered by a leverage increase depends on whether ‘the firm one is looking at is run by 2 CEO like Jane oF a CEO like Janet, When Janet increases her firm’ leverage, investors will infer that she is confident that the frm will be able to generate the cash flows to pay back the debt. They understand that she has Title incentive to give a false signal, but she has alot to lose ifthe frm subsequent fails to make the requited interest payments. Investors are likely to react much differently to a leverage increase initiated by Jane, They understand that Jane has a stron incentive to appear optimistic. even when she isnt, and thatthe cost 10 her of overleveraging her firm isnot substantial, Hence, an equivalent leverage inerease will resin a lower stock price response tothe leverage signal for Jane's firm than for Jane’, Adverse Selection Theory Consider a health insurance company offering two different policies. One policy is very «expensive, butt pays 100 percent ofall of your medical bills. The second policy is much less expensive, but it pays only 80 percent of your medical bills. How do you expect individuals to choose between the two policies? Most economists predict that individuals will not randomly select between the poli- cies. Rather, we will ebsorve what economists call adverse selection. Inthe health insur lance example, adverse selection means that individuals will select their best actions ‘based on thor private information. Hence, the more expensive policy will artrat the least bealthy individuals. An additional example of adverse selection, described in a seminalPuri twcetvs eormation. ond Coparae Contre article by Akerlof (1970), is the adverse selection or problem of “lemons” connected vith the sale of used cars, Akerlof argued that cars depreciate so much in thei frst year Targely because people who have the most incentive 1 sell their ears after only one year ae those with lemons, or faulty cus. Buyers, toking into account this adverse selection fof used cars, are thus unwilling to pay 3s much for a used ear as for anew car, which is Jess likey tobe a lemon, ‘Adverse selection also is important when firms issue new equity. Managers have the _reatest incentive to sll stock when the stock is lemon. This means that the incentive to issue equity is highest when management believes that the firms stock price exceeds its nirinsic value. At these times, equity provides relatively inexpensive financing (ie. the expected rein on equity is relatively low} and x new issue would thus increase the intrnsie value of existing shares. In contrast, issuing shares of stock at price lower than ‘what management believes they are worth provides relatively expensive financing and Aut the intrinsic value of the firm’ existing shares. Adverse Selection Problems When Insiders Sell Shares. The incentive to retain rather than issue underpriced shares can be viewed within the context of an entrepreneur ‘who is mativated to take his firm public in order to sel shares and diversify his por. folio.” To understand how an entreprencur decides bow many shares to sell, consider the situation faced by Bill Gates at the time of Microsoft's initial public offering. In deciding whether or not to sell some of his own shares, Gates has to consider: + The diversification benefits of selling shares. + The tax costs of selling shares (Gee Chapter 14), + Whether the shares are undervalued or overvalued If Gates values diversification andthe tx costs are not grea he wil sell shares ithe believes they are not substantially undervalued. Indeed, if he believes the shares are ‘overvalued, he wll ell them even if he places no value on diversification. Conversely, if Gates believes the shares are substantially undervalued, he will choose not to sell any shares even i he is extremely risk averse. ‘Since investors understand Gates’ incentives, they monitor his tendency to sell off shares when they value Microsoft stock (both atthe [PO and subsequently. in the sec~ ‘ondary market. I Gates were to selloff almest all of his shares. which he would do to Giversify optimally, Microsof’ stock wauld probably fll substantially because it would Signal to investors that Gates no longer believes that Microsoft stock isan extraordinary investment. Gates thus foces a tade-off. By holding more shares, he provides a more favorable signal about Microsofts prospects, which Keeps the share price relatively high However, this forces him to he less diversified than he would like to be. ‘Owing to the adverse selection problem, a corporate insider like Bill Gates needs « ‘good reason to sell his shares. To understand this argument, review the issues involved in buying a used car. IF you know thatthe car's owner is moving overseas, you might think the adverse selection problem is minimal and feel eomfoctable about buying the car, Similarly, i investors believe that Gates is extremely risk averse and therefore mot ‘ated to sll his shares, they will be less concerned about the adverse selection problem ‘nd be more willing to buy his shares, On the other hand, if investors believe that Gates, is not very risk averse but i extremely averse to paying taxes, they would be much less willing to buy his shares “Thasnses wee at addr in Leland a Pye 107)Chapter 18 The fafrmaton Comesed hy Fail Decisions 651 Several decades ago, Howard Hughes (whose sophistication with corporate finance theory was documented in Chapter 15°s opening vignete), soll a substantia Iraction of his holdings in TWA. stock. The stock price of TWA did not plummet i response to the sale because Hughes was able to credibly convince the market that he was selling TWA, stock to remedy a “cash crunch” that he was personally experiencing, and not because ‘of any adverse information he held about TWA. Adverse Selection Problems When Firms Raise Money for New Tavestments."" Firms often issue equity to raise capital to fund new investment. Inthe same way that is easier to sell your car when you can convince would-be buyers that you are moving ‘overseas, its easier to convince investors that your stock is not overvalued if you can {demonstrate that you are raising capital to fund tn attractive investment project. However, the adverse selection problem cannot always be scved by revealing the potential of a favorable investment. As result, rms sometimes pass up good invest. ‘ments because of their reluctance to finance projects by issuing underpriced share, The conditions under which a fim will pass up a positive NPV investment are seen in the following equations, which compare the intense values of a firm's shares with and ‘without now investmeat thats financed by issuing equity PV of asets in place + PV of new investment Number of original shares + Number of new shares V of assets in place ‘Number of original shares ‘Share value king the project ‘Share value not taking the project = ‘The equations show that a firm may reduce the intrinsic value ofits shares if the PY ofthe new investments low relative to the number of tharos it must issue, To understand this, consider a case where management believes the firm has assets worth $100 million with 1 million shares outstanding, suggesting thatthe fr intrinsie value is $100 per share if it doesnot rake any new investments, If tis firms stock is selling at only $70 per share it will have to issue an additional | milion shares to raise $70 million fora project that has a Value of $90 milion. The firms share value after taking the project woul then be 5100 million + $90 milion Trillion + Trillion °° PF share Hence, the firm reduces the intrinsic value of its shares by $5 per share by taking on positive WPV project. Although the projet has a positive NPY, the financing for the project has «negative NPV. This possblit is lluttated further in Example I8.. ‘When Managers Know More than Investors Cympus Corporation is currently soiling at $60 a share and has 7 milion shares cutstanding, ‘Tne'$50 shar pice reflec ts current business. valued at $40 millon and an opportunity to take on an investment valued at $30 millon, whch eoets only $20.milion. The opportunity ean be viewed as an asset with a$10 milion NPV “The management of Olmmpus has decovereda vast amcunt of i worth $50 millon on ts property. This acts unknown fo sharefolders end thus snot rellected in Olymauss curent share price information about this ol were known to shareholders, is shares woud sel ar 100 share. Unfortunatly, managementhas no way to reveal hi information ciety tothe market, 0 maragoment expocts thats shares willbe undervaluad for some tine. Taso nt sbeeton eased on Myers and Mat (1984),682 Result 18.10 Part tncemives, normation, nd Conporate Control ‘Suppose that the fm funds its new investment by issuing 400,000 shares at $50 a sharo. How wil this affect the btinsie value ofthe frm’ exiting shares? “Answer: I ho frm passes up the projects shares wile worth $90 each ($40 ition + {50 milfon/t millon] when the information about the olf revealed. However the project is taken and is francod with an equty issue, te tm’ total value wil be $120 maion ($40 milion + 530 millon + $50 milion) and the total number of shares outstanding wil be 1.4 milion. The per share value wil thus be only $85.71 (6120 ~ 1.4) yous issues shares ‘and takes the projet. Thus, the frm wil choose nat o invest inthe postive NPY pofec it requires issuing underprced equity Using Debt Financing to Mitigate the Adverse Selection Problem. Example 18.8 illustrates why managers may choose not to issue equity when they believe that their firms shares are underpriced. However, the example ignores the possiblity tha the firm can finance the projet with debt. I the projet can he inanced with riskless debt, then the firm should take the project as long as it has a positive NPV. In this case, the share's intvinsic value will be equal to: ‘Share value: financing profect _ Value of original assets + NPV of new project with skless debe Number of shares ‘This value clearly increases when the company commits 10 & positive NPV projec. However, the frm may still pass up the project if itis forced to issue risky debt that exposes it tothe possibility of incurring financial distress cost. n this case, a firm must, ‘compare the costs of deviating from its optimal cepital structure and the associated financial distress costs with the NPV of the particular investment project. Given this, comparison, some positive NPV investment projects will be passed up while others will be financed with det, causing the firm to become a least temporarily overlevered. ‘Similarly one could show that firms have an incentive to take on negative net present value projects and to become underlevered if it allowed them to issue overpriced secur ties. Because investors and analysts understand these incentives, issuing equity is consi ted to be an indication that a firm is overvalued, As a esl, announcements of eq issues have a negative effect on a firmis stock price, which has the further effect of reducing the incentive of firms to issue equity because, even ifthe firm were correctly priced prior tothe announcement of stock isu, the firms stock is likely to he under Priced atthe time of the offering This discussion suggests that managers will prefer debt to equity financing when they havea substantial amount of private information, In Example 18,8, Olympus Cor- poration would have been able to realize a shae price of $100 if could ave Nnanced the investment with risk-eee debt If lenders ave unviling to lend the firm akiional amounts (See Chapter 15) or ifthe firm is unwilling to borrow mote because of the ‘nancial distress costs (ee Chapter 16), then undervalued firms may choose 10 pass up Positive net preset value investments, [A firm may pass up » postive net present value investment project i it equies issuing tnderpriced equi. Since debt halders are aed claimant, frst fe less Likely to be substantially undervalued. Asa result, rns may have a bis toware nancing new project With ete rater than equity With sufcently high financial disiess coms, however frms may be beter off passing up the investment ther than financing it with deb Adverse Selection and the Use of Preferred Stock. Thedilution and financial distress problems that can arise when an underpriced firm finances a new project may be miti- sted by issuing preferred stock. Recall from Chapter 3 that profrted stock is similar toChaper 18. Te inf mation Comeved by Financial Drcions 63 4 bond because it has a fixed payout. However, if firm fails to meet is dividend obligation, preferred shareholders cannot fore it into anktuptey. Hence, preferred stock ‘will not create the problems associated with nancial distress. Inaddition, ince preferred stock offers a fixed claim, its not ikely tobe as underpriced a common stock, 50 the Ailution costs of issuing underpriced shares are much less ofa problem. For these reasons, preferred stock isa good security for Birms to issue when they ‘are having financial difficulties that they believe aze temporary. Investors donot agree thatthe difficulties are temporary, the common stock may be underpriced, so issting ‘common equity may dilute the value of existing shares. In such a situation, the frm may ‘ot have taxable earnings, making debt financing less attractive. Furthermore, additional ‘debt financing may lead to a drop in the firm's credit ating, which could ereate problems ‘with the firm's nonfnaneial stakeholders, referred stock may be the best financing alternative in this situation because i is unlikely to be as undervalued as common stock, given its senior status and fixed divi ‘ond, and it does not increase the risk of bankrupiey as would happen when additional debs is issued Result 18.11 When fms ar experiencing financial dificult, they prefer equity to dsb financing for a numberof reasons. In particular, the tax advantages af ving debt may he les and the Potential for suffering financial distress costs may he greater Ising cmon sock in these situations may bea problem, however. given the negative information conveyed by a ety offering. Hence, a prefered issuemay afer the bit sce of capital, Empirical Implications of the Adverse Selection Theory. ‘The ailverse selection ‘theory explains a numberof observations about how firms externally finance themselves, First, the reluctance of managers to issue underpriced stele halpe explain why stock Drices react unfavorably when firms announce their intention to issu equity, As we discuss in more detail in the section below, stock prices drop about 2 percent, on average, \when firms announce the issue of now equity. The adverse selection theory aso provides {an explanation for Donaldson's pecking order of financing choives (see Chapters 14 and 16). Donaldson observed that firms prefer frst o finance investment with etained earn ings: then, when they need outside funding, they prefer to issue debt instead of equi ‘The adverse selection theory explains the reluctance of firms to issue equity and, in Addition, suggests tht fis prefer to use their retained exenings to Hnance investnent ‘expenditures because this allows them toreain the eapacty to borrow in the fatare 18.6 Empirical Evidence Exhibit 18.3 provides « brief overview of three types of signaling theories that provide insights about financial decision making and the reaction of stock prices when firms ‘make financing and dividend charges. This soction discusses some of the empirical implications of those theories. We stet by reviewing academic studies thet examine empirically the stock price responses to these financial decisions. We wil then discuss some of the evidence relating to the effect of information issues on investment choices. What Is an Event Study? ‘Academic research that examines stock price responses tothe announcement of particu tar information is generally referred ro as an event study. For example, te event studies of dividend initiation announcements discussed previously were carried outa followsoss Part tncentes, efermaton, ond Corporate Contre ExWWsAr 18.3 Signaling Theories and Their Implications Theory Explanation Enpirieal Implications Tsing ty dite Management representing Selling hares to ute ren sheers ting shuchaiers, i iestrs conveys reluctant tose Sfvorale information Uderpricedshares. This andreuls in astock price reluctance resin elie. Sia. share fither umderimestment repurchase sulin stock roxas lveage pe intense. Distributing sho outside Cash outfows through Dividends, epureases, and ‘investors rovesl the Sividends,epuctases, debt reiementsconey Aimvearangreapacty® or dbl etements, favorable information ad roscalttat the erm has felt insnck price ‘eenandisespectedto erase Eguty and debt ontnde generting [Sues convey unfevoabie fuffiient cath ows Ssformaton The capil sructue choice Increatod debt signals that Increated leverage conveys Teveals marapemen| firme aeconiden:that forse informations essmentofthefirn’s they ean see higher ‘i anocited with postive Taare prospec. interest payments and ‘Sock price respons. ‘hat hey hae uficent BIT tose he nest ‘aah, ‘Seta as) 97 aaa ‘The researchers frst collected the dates when a sample of firms announced that they would be initiating new dividends. The stock returns on the announcement dates and the days immediately before and after the event were averaged across al fizms in the sample For example researchers might find thatthe average return fora sample of stocks on the ay of a divided initiation announcement was 3.0 percent, the average return on the day hefore the announcement was |.2 percent, and the averaze return on the day after the Announcement was 02 percent nis typical to fed significant returns onthe day(s) prior to & major announcement ‘because information sometimes leaks out early oF the press is slow to report the an nouncements. Therefore, researchers sometimes add the returns from the day() ine diately before the ammouncement tothe return on the snouncement date itself to gauge the events total price impact. For example, ane might say that the dividend initiation event led to an average return of 42 percent, the 3.0 percent return onthe event date pls the 1.2 percent return on the day prior tothe announcement, With efficient markets, one expects to see insignificant returns after the announcements, ‘As discussed below, there is evidence thatthe market underreaets to some informa tion events, and, consequently, some researchers also analyze returns on the day follow ing the event, Events where such underreaction occurs are known as efficient markets, ‘anomalies because the associated stock price reactions seem lo violate the efficient ‘markets hypothesis. At this juncture, we do not have a good explanation for why such ‘anomalies occu, although some research has suggested that flawed methodological do ‘sign may account for some of the observed underreaction.Chapter 18 The aivmation Conese by Finacial Decisions 65s ‘Stock Market Response to Pure Capital Structure Changes ‘peroge Aenean Bpcoftonmcion “ial eal’ “a Prlnggenn Leverage renin Tracts Scapa he common et Excungrotlee abt Connon 2 wo Bhameole? Pre Commin ee Behar? Date Prefered u @ Techngcof” Immense ae ‘Transactions th No Change n Leverage Eecngeoter pee ete 6 oe Seca sl Dex Daw Boor Leverage Reductng Teaactos overtr-trapea Comm Camere 57-0 Camersinformgea” Common eed ns Secaiy ai Comere debe Conerbictond 1s xcngcofl# Common Del » rennet” Pred refed ° Seca ld Common ate 2 Eecaugroflt# Comment oe: os Wa re gy ren ee peri Sah ‘Sots san, "Mae, Tee ees ice enn ay hth il ofa fr shou 4 pee he ‘stop ottondsomeanent apc rm ft ge, ‘Mie eeu 8) ‘Tete (988 a Miers ndash 86, In some event studies, researchers average market-adjusted excess returns instead of averaging total returns on the event dates. A murketadjusted excess return is the stock's return les the stock’ beta times the market return on that date. For example, the ‘market-adjusted excess return of a stock whose beta equaled 1 would be the return on the event day less the market reurn for that day. For relatively small samples, market adjustments are important because, by coincidence, particular announcements may be ‘made on days when market returns are high. For large samples, however, itis unlikely that market returns will be either unusually high oF unusually low on announcement dates, so that adjusting the returns for market movements makes litle difference in these Event Study Evidence Capital Structure Changes. Fitms sometimes make capital structure changes that hhave no immediate effect on the asset side of their bulance sheets, or example, a firm ‘may issue equity and use the proceeds 10 pay down debt, Exhibit 18.4 summarizes &656 Part tacenties,efermation om Corporate Conve EXiimr IBS Stock Price Reactions to Security Sales Two-Day Announcement pest Ansoancement Average Sample Size Petiod Rete Security Sale ‘Common wok 282 Prefered sock® 2 ou Convertible preferred! 20 ‘Staight dee? 2 ‘Convert debe! 0 ma ‘Dans Mihatoe 58), e198 au6 Mien aaah. 198) “Inept he aborigines ‘number of event studies that examine average stock price movements sround the time of the announcements of these pure capital structure changes, ‘The evidence summarized in Exhibit 18.4 indicates that leverage-inereasing events tend 0 increase stock prices and leverage decreasing events tend to decrease stock prices. For example, Masulis (1983) found that at the time of the announcement of exchange offers (in which common stock is retired and debt i issued), stock prices increased pout 14 percent, on average. He also fOund that announcements of levrage-Jeereasing exchange offers brought stock prices down 9.9 percent. This evidence supports the ides that higher leverage is a signal that managers are confident about their ability to meet the higher interest poyments Exhibit 18.5 summarizes a number of event studies that examine stock price reactions to the announcements of new security isues. It shows that raising capita is Viewed asa negative signal. For example, the announcement ofthe issuance of common stock results in a stock price decline, on average, of about 1.7 percent. This evidence supports the ides that ime seck outside equity when they think they can oblain cheap financing (ce, sete overpriced stock) and the idea that by essing outside capital, firms reveal that they have generated insufficient capita internally. In a sens, firme rising new debt are sending 4 mixed signal. They are seeking funds, sich investors consider bad news, but they ate increasing leverage, which inves- tors below is good news. As a result, when firms announce that they wil issue straight bonds, their stock prices generally react very little. However, issuing convertible bons, an instrument that shares debt and equity characteristics, results in negative stock price Explanations for the Event Study Results. ‘These empirical findings are consistent with the adverse selection theory, which states that firms are reluctant to issue common, stock when they believe their shares are underpriced. When firms do issue shares or, alternatively, exchange shares for bonds, management generally believes that the shares are probably either priced about right or overpriced. Analysts and investors observing the announcement ofa share issue will then infer that management isnot as optimistic asthey had earlier thought, which is bad signal about curren share pricesResult 1812 (Chaper 18 The Ifrmation Convey Financial Decions os Since convertible bonds have strong equity-like component, the averse selection sheory also can explain why the stock market geosrally reacts negatively when they a Jssued. On the other hand, short-term ank dsbt is leas subject to adverse selection. Firms that believe that ther stock i undervalued and that thee ret ratings wl i prove in the future have the greatest incentive to borrow short term." As a result, investors usually see short-erm borcowing a favorable signal ad, a lames (1987), showed, stock prices generally respond favorably when firms increase their bank debt ‘The adverse selection theory aso explains the stock price increases around the snmouncements of share repurchases and exchange offers that rece the number of outstanding shares. Since management his the greatest incentive to reduce the total number of outstanding shares when their ems stock is underpiced, these announce ‘ments convey favorable information othe market The discussion of taxes and financial distress cons provides an addtional expana- tion for why stoek prices rise when firms increas their deb levels. Managers would be Jes ling o replace equity financing with debt if they thought they were nt gong {generate sufficient income tlie the tax benefits ofthe de or if they thought eye ing the debt would create problems. Thus, when fms increase ther leverage, investors a likly to believe that mazagement is unconcerned about either nancial dstess or >hving excess tax shield. Since thi usualy implies that manage ace optimistic. lever ge increases shouldbe viewed as god news for sharers. ‘The events considered inthis section may also be signals of the intentions as well as {he information of managers. For example, as Chapter 17 discussed, managers may have an incentive to overnvest, faking negative net preset value projects that benefit them Fersonaly: Shareholders may ee distribution of eash or am increas in leverage as a Signal that managers donot plan on inating what the shareholder view ae wasteful investment A Summary of the Event Study Findings. Result 18.12 provides a summary and imerpretation of some of the more notable event study findings. (On average, stock pices feat favorably to: + Announcements tha firms will be distributing cath to shareholders, + Ammouncemenis that firms wll increase their kverage, ‘Stock prices react negative, on average 10 + Announcements that ims willbe raising cas + Anouncemenis that ims wil decease their leverage These announcement returns can be explained by the information theories presented in his chapter andthe incentive theories presented in Chapter 17 Differential Announcement Date Returns. Recall fom this chapter's discussion of| averse selection that the information conveyed by an equity or debt issue depends on the manager’ perceived motivation fr isving the particular financial instrument. For ‘cxample if investors belive thata firm already overlevereged and eannoteasily finance ‘new investments with deb, then they are likely to view an equity offer less negatively and a debt offering as evidence that managers believe their stock is undervalued. In Contrast, investors are likely 1o view an equity offering as especially negative in cases "is Meats veloped in much greater deta i lane (1986) and Dimond (1991,658 Result 183 Part V-twcenvesiefrmeton ond Corparte Control where the frm could easily aise deb capital In such instances, investors may conclude that managers arc ising equity because they believe their stock is overvalued ‘To examine these possibilities, Bayless and Chaplinsky (1991) developed a model based on variables such aa firnis taxcpaying staus, a firm's debt ratio relative 10 is historical average ratio, and other firm characteristics to predict which firms are the most likely to issue equity and which are the most likely 10 issue debt. They compared the stock market responses aroune the time that debt and equity isues are announced to determine how expectations regarding the financing instrument thatthe firm is likely to issue affect stock reutns. “The evidence inthis study is consistent with the predictions ofthe theory of adverse selection, Stock returns around the time of equity announcement are more negative for firms tha are expected to use debt financing and less negative for firms expected toissue equity: Postannouncement Drift. The event studies described in this section assume that markets are efficient and that stock prices react fully wo the information eveat under ‘consideration. However, some recent studies have shown that ina surprising number of ‘eases, the market substantially underreacts 10 important information. This was fist shown in the context of earnings announcements, where research indicates that stock prices react favorably to announcements of unexpectedly good earnings, but tend to lunderreact to this information. As a result, investors can profit by buying stocks imme: diately afer the announcements of unexpected good earnings and selling the stocks of Firms whose earings fall below expectations.” Michaels, Thaler, and Womack (1995) found that stock prices underreact 10 the announcement of both dividend initiations and emissions. They found market-idjusted excess returns averaged about 15 percent over the two years following a dividend initia~ tion and aout ~15 percent following a dividend omission. This means tha, historically, the market has substantially underzeacted o these dividend events. ‘Loughran and Riter (1995) and Ikenberry, Lakonishok, and Vermaelen (1995) doc lumented similar results for equity issues and share repurchases. Stocks realize negative returns over the five years following an equity issue and positive returns over the fout years following shave repurchases, These results suggest that rms have historically been able to time the equity market successfully issuing stock when itis overpriced and fepurchasing stock when it is underpriced Recent evidence suggeststhat the market undereacts tthe information revealed by earninas ‘sports and announcements of some financial deesios. Inthe past, investors could hive fererted substantial profs by buying tacks following favorable smnouncements and eling Socks fllowingunfaverable amouncemens ‘We stress that most financial economists are generally skeptical about purported ‘market ineficiencies and tend to belive thatthe observed return. premium associated ‘with simple trading strategies compensates for some sor of risk, However, no convincing Fisk-based explanations forthe investment strategies described in Result 18.13 have been proposed. Of course, even a market that was inefficient in the past may not continu to bbe goin the future. We thus urge readers who plan to implement trading strateies to take advantage ofthese apparent inefficiencies to exercise caution fait dacuen these bor post sings snnsetent turns nade, Fst, Olen andChapt 18 The formation Convey by Financial Decisions 639 How Does the Availability of Cash Affect Investment Expenditures? According to the adverse selection theory, firms will sometimes choose not to issue equity and will instead pass up positive net present value investments when they are unable to horsow. Therefore, the theory suggests that firm's borrowing capacity and the valability of eash may be important determinants ofits investment expenditures, The effect of the availabilty of cash on investment choices is Ulustated in the following discussion with Daa Franchi the assistant reasurer st Unocal. When asked how changes in cash flow affect Unocal’ investment expenditures, Franchi replied fo prices were wo dp S4 per bare, Unocal would ext back Funding for capital expend tures. because ofthe lack of ava eas, not heease the projets became considerably ‘wors. The additional projeews that ae taken when cash lows Are high ace projects tht ‘wool have been attractive anyway. but Would have boen delved if we had insult Sterna fs ‘Unocal generally does not consider common stock issuance tobe an attractive alter native for raising investment capital in the event of a cash shortfall caused by a drop in oil prices. In addition, the company is generally unwilling to fund new investments wih debt if it means lowering is eredit rating. Franchi indicated thatthe company was con- cerned that a weakened credit rating would put Unocal at a competitive disadvantage in attracting business overseas: ‘We feel shat over the long term, wee going to be competing with companies overseas thst tend io have A creit ating. Ass BBS company, we Noud beat a compete dindvantage Inne tong term. Potentially, when afoeign government decides whe they would ike 10 have working ona project, they cou be looking a the nana strengths of the company. And they would be more likey o want 0 work wih 2 eampan) tat wore Knanely Sound. For example al else gus, the Chinese goverment would rather errs long term arrangement with AAA company tan a BBB company.” Empirical Evidence in the United States. A sulstantal amount of empirical evidence suggests that there i fairly widespread tendency of firms to determine their level of investment expenditures a leas! partially based on the availability of cash low, as the adverse selection theory predicts. Meyer and Kuh (1957), Pazzari, Hubbard, and Peter sen (1988), and others documented that year-to-year changes in firms’ capital expendi- tures are highly correlated with changes in their cash flows (net earnings phis deprecation), but they are much less correlated with changes in their stock prices Favzari, Hubisrd, and Petersen found that the tendency to link new investment expen litres to the availabilty of cash flows is greater for firms that pay low dividends, which are more likely to be cash constrained. Such firms generally have greater investent ‘needs than firms tht pay higher dividends, which presumably generat more cash Row than is required for their relatively low investment need. Empirical Evidence in Japan, ‘The relation between cash lows and investment for USS firms also holds for some firms ia Japan, The investment expenditures of Japanese firms was analyzed by Hoshi, Kashyap, and Seharstein (1991) ina study that examined the differences between firms associated with a keiretsu family and independent firms. ‘As Chapter 1 noted, a heirersu family isa group of firms with interlocking ownership “Dan Fanti leone comersaton ih ono the ator May 2,188,660 Fut tacemies,efeemation. ond Coporte Com structures, which prefer to do business with each ether rather than with firms outside the group. The keirrsu firms ave usually headed by a large bank which supplies a major portion of the debt as well 3s some of the equity capital to the firms. The interlocking ‘ownership structure ofthese keivetsu firms makes it virtually impossible for outsiders to ‘mount a successful hostile takzover of one of them. In addition, the close ties with a ‘major bank means, on the one hand, that the mangers are more closely scrutinized by the suppliers of capital but, on the other hand, that the Keiret fms enjoy greater access to capital when they have investment projects that enhance the value of the fem, ‘Not sup Independent Japanese firms, 18.7 Summary and Conclusions (Otten, a fms managers posses information that ouside investors lack. This chapter examined how these die fences in information influence Bnancal decisions, The analysis suggested that if managers” objective place sig- nieant weight on the curret share pice, these infor tation differences wil distor inaneial decisions ini portant ways. For example, fms wil end 1 invest lest And bias their investments toward projects that pay off ‘more quickly Firms also wll pay out higher dividends ‘tnd choose tb be more highly Tevered than they would ‘Since the distortions that arise from thse infoemton Aitferences are cosy. manages have an incentive to ake Steps that minis the distortions, One way to reduce these information related coat isto inerare the infor: ‘mation avalableto analysts and investors, thus decreasing ‘managements information advantage. Doing this redaces the extent 10 which ouside investors mistely on indirect Key Concepts Result 8 Management incentives ar innced by Adee toinerave te tris curone Shar pice ands nine ae The ‘ishthat managers pace on hese potently coficingcenines ic ‘ermine! ty among te ng, Imanager’s compenation andthe secuity the manager. ‘Good dois cn evel nftvorable infomation and bad decison can eel {tseabe information, Thi tea fa ingly, the investment expenditares of the Keiretsu firms are much less tied to their cash flows and much more ied to their stock prices i either USS. firms or Indicators of value, suchas dividends nd debt ratios, hat ‘management can manipulate tthe fem’ long-term dtri- ment. One also could reduce the severity of the informa "on problem by designing compensation packages that reducea manager’ incentive to inereave the firms current ook price, Ts unrealistic, however, 10 think that the distortions ‘caused by information differences canbe eliminated com- pletely. The compentive disadvantages of making too much information atour the frm puble mit the aout that fis sous! dinchne. Moreover, as Chapeer 17 em ‘phasized, ofseting incentive problems exist when mat ‘agers ae Indifferent to their hea current stock pie. In ‘eal, ims need to skew balance between the mot ational Benefit of having a id job marks that requis ‘compensation based on short-erm performance and the ost ancciated ith the potential shortightedaes that ‘sch compensation plan promote + Stock pice reactions are sometimes ‘oor indicators whether ‘cision ana positive or a negative effect ona fees intrinsic valve, + Managers who are concerned about the eurent share prices of ther firms ‘ay bas their deisions in ways that reduce the insrinsie vale of their fires Result 183: Managers wil clot projets that pay off ‘quickly over possibly higher NPV"Result 18: Result 18S: Result 186: Result 18.75 Result 188: (Chaps 18 The lfrmation Conve by Fnac Decisions 661 projects thar pay outer longer periods {bey place significant weight on increasing their emis eure tock piss Stock prices increase on werage, when firms ncrese divides and decrease, on sverage, when they decrease dividens, ‘An increased dividend implies, holding all ese constant, higher cash Nows and hence higher sock prices. By cuting Snvestments in tems that cannot be roadily observed by snslyts, fans increase reported earnings and Avid, thereby increasing their stock prices, A manger’ incentive to Temporarily boot the fms stock prise ray ths ead the fen to pase up positive rt peseat value investment Tis unlikely that signaling considerations explain why Bem pay dividends euler ‘han repurchase shes A dividend increase or decrease can rove information o inventors about +The firms cath ows. + Management’ investmeat intentions. In the later case, i iavestos belive tha Imotvated by improved prospects, they wil view the dividend cit avery However if investors lieve tat ‘manager wll make negative et presi ‘alu vestments, they ill intespst a ‘ividend cut as bad news, ‘Am increase in firms debt rt is Considered favorable signal because it indicaten that mmagers belive the em vl be generating able earings in the Faure and that thy ae ot overly ‘concerned about incurring nana “stress corte. Managers understand tht their emis stock pice key to respond favorably to high leverage ratios and ray thas have sn apcemine to select, higher leverage ratios thas they would otherwise peter, For a financial decision credibly comey favorable information t investors, "ems ith poor prospects must in ie costly mime the decisions made by firme sith favorable prospect, Result 18.10 esl 18.1 Result 18.12: Result 18.13 ‘A frm may pass up postive et present Sale investment project Ireguies issuing underpriced equity Since debe holders are ited clam fis deb is les likely oe substantially undervalued. As rest, rns nay have bias toward financing new projects with Sebi rather than equity. With sufeely high Snancial distress cost, however, lems may be beter off pacing op te investment rather than fnancing with debe ‘Wien firms are experiencing financial ities they prefer equity to debt Financing fra aber of reasons In parila, he tax advantages of ving febr maybe es nd the potential for sullering financial dies costs ay be treater sting commen stock in these situations may bea problem, however, ven the negative information conveyed ban equity offering. Hence, preferred issue may offer the best source of capital On averave, stock pies reat favorably to: + Announcements that irs wil be “istabating eas to snarenolcers + Announcements that firms will Increase thet leverage, Stock prices react negnvey.on erage to ‘Announcements tha ims will be raising eas + Anouncerents ha fies will ‘ecto thee leverge ‘These announcement turns can be explained by the information theories presented in his chapter and the inoentine theories presented in Chae 17 Recent evidence suggests hat the market snderteats tothe information eval by farsngs reports and announcement Seme financial decisions. In the past, investors could have generated sabetasiad rots by buying stocks following favorable amouncements and eling stocks following unfavorable