19.6Empirical Evidence

Exhibit 19.3 provides a 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 changes. This section discusses some of the empirical

implications of those theories. We start by reviewing academic studies that measure the

stock price responses to these financial decisions. We will then discuss the evidence on

the information signaled by investment choices.

What Is an Event Study?

Academic studies that examine stock price responses to the announcements of partic-

ular information are generally referred to as event studies. For example, the event stud-

ies of dividend initiation announcements discussed previously were carried out as

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Chapter 19

The Information Conveyed by Financial Decisions

679

EXHIBIT19.3Signaling Theories and TheirImplications

Theory

Explanation

Empirical Implications

Issuing equity dilutes	Management, representing	Selling shares to outside
current shareholders.a	existing shareholders, is	investors conveys
	reluctant to issue	unfavorable information
	underpriced shares. This	and results in a stock price
	reluctance results in	decline. Similarly, share
	either underinvestment	repurchases result in stock
	or excessive leverage.	price increases.

Distributing cash to outside	Cash outflows through	Dividends, repurchases, and
investors reveals the	dividends, repurchases,	debt retirements convey
firm’s earnings capacity.b	or debt retirements	favorable information and
	reveal that the firm has	result in stock price
	been and is expected to	increases. Equity and debt
	continue generating	issues convey unfavorable
	sufficient cash flows.	information.

The capital structure choice	Increased debt signals that	Increased leverage conveys
reveals management’s	firms are confident that	favorable information and
assessment of the firm’s	they can meet higher	is associated with positive
future prospects.c	interest payments and	stock price responses.
	that they have sufficient
	EBITto use the interest
	tax shields.

^aSee Leland and Pyle (1977) and Myers and Majluf (1984).

^bSee Miller and Rock (1985).

^cSee Ross (1977).

follows: The researchers first 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 all

firms in the sample. For example, researchers might find that the average return for a

sample of stocks on the day of a dividend initiation announcement in the press was 3.0

percent, the average return on the day before the announcement was 1.2 percent, and

the average return on the day after the announcement was 0.2 percent.

It is typical to find significant returns on the day(s) before a major announcement

because information sometimes leaks out early or the press is slow to report the

announcements. Therefore, researchers sometimes add the returns from the day(s)

immediately before the announcement to the return on the announcement date itself to

gauge the event’s total price impact. For example, one might say that the dividend ini-

tiation event led to an average return of 4.2 percent, the 3.0 percent return on the event

date plus the 1.2 percent return on the day prior to the announcement. With efficient

markets, one expects to see only insignificant returns after the announcements. How-

ever, as discussed below, there is evidence that the market underreacts to some infor-

mation events, and, consequently, some researchers also analyze returns on the days

following the event.

In some event studies, researchers average market-adjusted excess returns instead of

averaging total returns on the event dates. Amarket-adjusted excess returnis the stock’s

return less the stock’s 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 return for that day. For relatively small samples, market adjustments

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680Part VIncentives, Information, and Corporate Control

are important because, by coincidence, particular announcements may be made on days

when market returns are high. For large samples, however, it is unlikely that market

returns will be either unusually high or unusually low on announcement dates, so that

adjusting the returns for market movements makes little difference in these cases.

Event Study Evidence

Capital Structure Changes.Firms sometimes make capital structure changes that

have no immediate effect on the asset side of their balance sheets. For example, a firm

may issue equity and use the proceeds to pay down debt. Exhibit 19.4 summarizes a

number of event studies that examine average stock price movements around the time

of the announcements of these pure capital structure changes.

The evidence summarized in Exhibit 19.4 indicates that leverage-increasing events

tend to increase stock prices and leverage-decreasing events tend to decrease stock

EXHIBIT19.4Stock Market Response to Pure Capital Structure Changes

			Two-Day
		Average	Announcement
Security	Security	Sample	Period Return
Type of TransactionIssued	Retired	Size	(%)

Leverage-Increasing	Transactions:
Stock repurchasea	Debt	Common	45	21.9%
Exchange offerb	Debt	Common	52	14.0
Exchange offerb	Preferred	Common	9	8.3
Exchange offerb	Debt	Preferred	24	2.2
Exchange offerc	Income bonds	Preferred	24	2.2

Transactions with No Change in Leverage:
Exchange offerdDebt	Debt	36	0.6o
Security salee			o
Debt	Debt	83	0.2

Leverage-Reducing Transactions:
Conversion-forcing calle				0.4o
Common	Convertible	debt	57
Conversion-forcing calle
Common	Preferred		113	2.1
Security salefConvertible debt	Convertible	bond	15	2.4
Exchange offerbCommon	Debt		30	2.6
Exchange offerbPreferred	Preferred		9	7.7
Security salefCommon	Debt		12	4.2
Exchange offerb
Common	Debt		20	9.9

Note: Exhibits 18.4 and 18.5 are slightly altered versions of tables reported in Smith (1986).

Sources:

^aMasulis (1980).

^bMasulis (1983). These returns include announcement days of both the original offer and, for about 40 percent of the

sample, a second announcement of specific terms of the exchange.

^cMcConnell and Schlarbaum (1981).

^dDietrich (1984).

^eMikkelson (1981).

^fEckbo (1986) and Mikkelson and Partch (1986).

^oNot statistically different from zero.

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681

prices. For example, Masulis (1983) found that at the time of the announcement of

exchange offers(in which common stock is retired and debt is issued), stock prices

increased about 14 percent, on average. He also found that announcements of leverage-

decreasing exchange offers brought stock prices down 9.9 percent. This evidence sup-

ports the idea that higher leverage is a signal that managers are confident about their

ability to meet the higher interest payments.

Issuing Securities.Exhibit 19.5 summarizes a number of event studies that examine

stock price reactions to the announcements of new security issues. It shows that rais-

ing capital is viewed as a negative signal. For example, when industrial firms issue

common stock their stock prices decline, on average, about 13.1 percent. This evidence

supports the theory that firms seek outside equity when they think they can obtain cheap

financing (that is, issue overpriced stock) as well as the theory that by raising outside

capital, firms reveal that they have generated insufficient capital internally.

In a sense, firms raising new debt are sending a mixed signal. They are seeking funds,

which investors consider bad news, but they are increasing leverage, which investors

believe is good news. As a result, when firms announce that they will issue straight bonds,

their stock prices generally react very little. However, issuing convertible bonds, an instru-

ment that shares debt and equity characteristics, results in negative stock price reactions.

Explanations forthe Event Study Results.These empirical findings are consistent

with the adverse selection theory, which states that firms are reluctant to issue com-

mon 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 of a share issue will then infer that management is not as

optimistic as they had earlier thought, which is a bad signal about current share prices.

Since convertible bonds have a strong equity-like component, the adverse selection

theory also can explain why the stock market generally reacts negatively when they are

EXHIBIT19.5Stock Price Reactions to Security Sales

		Two-Day Announcement
Type of Announcement	Average Sample Size	Period Return

Security Sales:
Common stock (industrial issuers)a	216	3.1
Common stock (utility issuers)a	424	1.4
Preferred stockb	102	0.1o
Convertible preferredc		o
	30	1.4
Straight debtd
	221	0.2
Convertible debtd
	80	2.1

Sources:

^aThese figures are based on calculations by Eckbo and Masulis (1995). See also Asquith and Mullins (1986), Masulis

and Korwar (1986), Mikkelson and Partch (1986), Schipper and Smith (1986), and Pettway and Radcliff (1985).

^bLinn and Pinegar (1988) and Mikkelson and Partch (1986).

^cLinn and Pinegar (1988).

^dDann and Mikkelson (1984), Eckbo (1986), and Mikkelson and Partch (1986).

^oNot statistically different from zero.

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682Part VIncentives, Information, and Corporate Control

issued. On the other hand, short-term bank debt is least subject to adverse selection.

Firms that believe that their stock is undervalued and that their credit ratings will

improve in the future have the greatest incentive to borrow short term.¹²As a result,

investors usually see short-term borrowing as a favorable signal and, as James (1987)

showed, stock prices generally respond favorably when firms increase their bank debt.

The adverse selection theory also explains the stock price increases around the

announcements of share repurchases and exchange offers that reduce the number of

outstanding shares. Since management has the greatest incentive to reduce the total

number of outstanding shares when their firm’s stock is underpriced, these announce-

ments convey favorable information to the market.

The discussion of taxes and financial distress costs provides an additional expla-

nation for why stock prices rise when firms increase their debt levels. Managers would

be less willing to replace equity financing with debt if they thought they were not going

to generate sufficient income to utilize the tax benefits of the debt or if they thought

repaying the debt would create problems. Thus, when firms increase their leverage,

investors are likely to believe that management is unconcerned about either financial

distress or having excess tax shields. Since this usually implies that managers are opti-

mistic, leverage increases should be viewed as good news for shareholders.

The events considered in this section may also be signals of the intentions as well

as the information of managers. For example, as Chapter 18 discussed, managers may

have an incentive to overinvest, taking negative net present value projects that benefit

them personally. Shareholders may see a distribution of cash or an increase in lever-

age as a signal that managers do not plan on initiating what the shareholders view as

wasteful investment.

ASummary of the Event Study Findings.Result 19.12 provides a summary and

interpretation of some of the more notable event study findings.

Result 19.12

On average, stock prices react favorably to:

•	Announcements that firms will be distributing cash to shareholders.
•	Announcements that firms will increase their leverage.

Stock prices react negatively, on average, to:

•	Announcements that firms will be raising cash.
•	Announcements that firms will decrease their leverage.

These announcement returns can be explained by the information theories presented in this

chapter and the incentive theories presented in Chapter 18.

Differential Announcement Date Returns.Recall from this chapter’s discussion of

adverse selection that the information conveyed by an equity or debt issue depends on

the manager’s perceived motivation for issuing the particular financial instrument. For

example, if investors believe that a firm is already overleveraged and cannot easily

finance new investments with debt, then they are likely to view an equity offer less

negatively and a debt offering as evidence that managers believe their stock is under-

valued. In contrast, investors are likely to view an equity offering as especially neg-

ative in cases where the firm could easily raise debt capital. In such instances,

investors may conclude that managers are issuing equity because they believe their

stock is overvalued.

¹²This

idea is developed in much greater detail in Flannery (1986) and Diamond (1991).

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Chapter 19

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683

To examine these possibilities, Bayless and Chaplinsky (1991) developed a model

based on variables such as a firm’s tax-paying status, a firm’s debt ratio relative to its

historical average debt ratio, and other firm characteristics to predict which firms are

the most likely to issue equity and which are the most likely to issue debt. They com-

pared the stock market responses around the time that debt and equity issues are

announced to determine how expectations regarding the financing instrument that the

firm is likely to issue affect stock returns. Their evidence is consistent with the pre-

dictions of the theory of adverse selection. Stock returns around the time of equity

issuance announcements are more negative for firms that are expected to use debt

financing and less negative for firms expected to issue equity.

Postannouncement Drift.The event studies described in this section assume that

markets are efficient and that stock prices react fully to the information event under

consideration. However, some recent studies have shown that in a surprising number

of cases, the market substantially underreacts to important information. This was first

shown in the context of earnings announcements, where research indicates that stock

prices react favorably to announcements of unexpectedly good earnings, but tend to

underreact to this information. As a result, investors can profit by buying stocks imme-

diately after the announcements of unexpected good earnings and selling the stocks of

firms whose earnings fall below expectations.¹³

Michaely, Thaler, and Womack (1995) found that stock prices underreact to the

announcement of both dividend initiations and omissions. They found market-adjusted

excess returns averaged about 15 percent over the two years following a dividend ini-

tiation and about 15 percent following a dividend omission. This means that, histor-

ically, the market has substantially underreacted to these dividend events.

Loughran and Ritter (1995) and Ikenberry, Lakonishok, and Vermaelen (1995) doc-

umented 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 four

years following share repurchases. These results suggest that firms have historically

been able to time the equity market successfully, issuing stock when it is overpriced

and repurchasing stock when it is underpriced.

Result 19.13

Empirical evidence suggests that the market underreacts to the information revealed by earn-ings reports and announcements of some financial decisions. In the past, investors couldhave generated substantial profits by buying stocks following favorable announcements andselling stocks following unfavorable announcements.

We stress that most financial economists are generally skeptical about purported

market inefficiencies and tend to believe that the observed return premium associated

with simple trading strategies compensates for some sort of risk. However, no con-

vincing risk-based explanations for the investment strategies described in Result 19.13

have been proposed. Given this lack of a convincing risk-based explanation, financial

economists have started to consider behavioral explanations. For example, a paper by

Daniel, Hirshleifer, and Subrahmanyam (1998) suggests that investors often underreact

to information provided by managers because they tend to be overconfident about their

knowledge of the firm before the disclosure. In particular, since these investors think

they have a precise valuation of the firm before the announcement, they update their

valuation very little when they receive new information. This explanation, which

¹³Studies

that document these abnormal post earnings announcement returns include Foster, Olsen,

and Shevlin (1984), and Bernard and Thomas (1989, 1990).

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684Part VIncentives, Information, and Corporate Control

implies that financial markets do not efficiently incorporate new information, suggests

that there can be profit opportunities available to savvy investors that exploit the ten-

dency of stock prices to underreact to information events. Of course, even a market

that was inefficient in the past may not continue to be so in the future. We thus urge

readers who plan to implement trading strategies that take advantage of these apparent

inefficiencies to exercise caution.

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 borrow. Therefore, the theory suggests that a firm’s borrowing capacity and

the availability of cash may be important determinants of its investment expenditures.

The effect of the availability of cash on investment choices is illustrated in the fol-

lowing discussion with Dan Franchi, the assistant treasurer at Unocal. When asked how

changes in cash flow affect Unocal’s investment expenditures, Franchi replied:

If oil prices were to drop $4 per barrel, Unocal would cut back funding for capital expen-

ditures . . . because of the lack of available cash, not because the projects became consid-

erably worse. The additional projects that are taken when cash flows are high are projects

that would have been attractive anyway, but would have been delayed if we had insuffi-

cient internal funds.¹⁴

Unocal generally does not consider common stock issuance to be 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

with debt if it means lowering its credit rating. Franchi indicated that the company was

concerned that a weakened credit rating would put Unocal at a competitive disadvan-

tage in attracting business overseas:

We feel that over the long term, we’re going to be competing with companies overseas that

tend to have Acredit ratings. As a BBB company, we would be at a competitive disadvan-

tage in the long term. Potentially, when a foreign government decides who they would like

to have working on a project, they could be looking at the financial strengths of the com-

pany. And they would be more likely to want to work with a company that is more finan-

cially sound. For example, all else equal, the Chinese government would rather enter a long-

term arrangement with a AAAcompany than a BBB company.¹⁵

Empirical Evidence in the United States.Asubstantial amount of empirical evi-

dence suggests that there is a fairly widespread tendency of firms to determine their

level of investment expenditures at least partially based on the availability of cash flow,

as the adverse selection theory predicts. Meyer and Kuh (1957), Fazzari, Hubbard, and

Petersen (1988), and others documented that year-to-year changes in firms’capital

expenditures are highly correlated with changes in their cash flows, but are much less

correlated with changes in their stock prices. Fazzari, Hubbard, and Petersen found that

the tendency to link new investment expenditures to the availability of cash flows is

greater for firms that pay low dividends, which are more likely to be cash constrained.

Such firms generally have greater investment needs than firms that pay higher divi-

dends, which presumably generate more cash flow than is required for their relatively

low investment needs.

14

Dan Franchi, telephone conversation with one of the authors, May 2, 1995.

¹⁵Ibid.

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Empirical Evidence in Japan.The relation between cash flows and investment for

U.S. firms also holds for some firms in Japan. The investment expenditures of Japa-

nese firms was analyzed by Hoshi, Kashyap, and Scharfstein (1991) in a study that

examined the differences between firms associated with a keiretsufamily and inde-

pendent firms. As Chapter 1 noted, a keiretsufamily is a group of firms with inter-

locking ownership structures, which prefer to do business with each other rather than

with firms outside the group. The keiretsufirms are usually headed by a large bank

which supplies a major portion of the debt as well as some of the equity capital to the

firms. The interlocking ownership structure of these keiretsufirms makes it virtually

impossible for outsiders to mount a successful hostile takeover of one of them. In addi-

tion, 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

keiretsufirms enjoy greater access to capital when they have investment projects that

enhance the value of the firm. Not surprisingly, the investment expenditures of the

keiretsufirms are much less tied to their cash flows and much more tied to their stock

prices than are the investments of either U.S. firms or independent Japanese firms.