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Our third look at capital structure. This week we tackle Capital
Structure and Signaling
Capital Structure and
Signaling
Have you ever noticed that when a firm issues new securities, the price
of
the existing securities falls? Why is that?
There are many reasons for this negative reaction to issuances. One
reason is due to signaling. Managers have better information than
investors do. This is the basic idea of an information asymmetry.
Managers can lessen the information differences by releasing information.
The problem is that managers are less than credible sources of
information. They have an incentive to makes themselves and their firm
seem better than reality. In finance-speak, managers are REMPS
(Resourceful, Evaluative, Maximizers) who look out chiefly for their
own
best interests.
Investors know this and therefore watch managers words and actions
closely. As they say “Actions speak louder than words.” Thus, no matter
what the manager says, what he/she does dominates.
Firms raise new funds for many reasons. They may have great investment
opportunities or may have a cash shortfall due to disappointing results.
Of course if the firm needs cash for new investments the stock price
should rise. However, if the reason the firm needs the cash is that
they
are not doing as well as expected, the stock will fall. Managers
generally will say they need the cash for investments, but investors
know
better. They fear that managers are lying and instead assume that the
sale must say something bad about the firm’s cash flow. This causes
investors first reaction to an issuance to be negative. That is one
reason why most issuances are not with negative stock moves. Another
equivalent way of looking at equity issuances is that the firm is selling
because the stock is overvalued. (Note the reverse of this is also
true, a
stock is seen as a good signal).
Leverage is another name for debt. Why? Just like a lever, debt
magnifies results. Debt makes good times better and bad times worse.
As
my students will tell you, that is important. In fact it is so important
I will write it again: Debt makes good times better and bad times worse.
Why is this so? Because the payments to debt holders are fixed. Thus
in
good times you can make the payment and do not have to share the success
but in bad times the same payment must be made which leaves little
for
shareholders.
Following this reasoning when a manager expects the bad times ahead,
the
firm will issue equity. Conversely, if good times are ahead, the firm
will lever up. Thus increases in leverage will be good news, while
decreases will be bad news.
More on this, and a great matrix summarizing the market response to
virtually every capital structure event can be found in the Smith and
Masulis 1986 paper.
http://www.financeprofessor.com/488/smith%20and%20masuilis%20tables.doc
Myers and Majluf (1984) looked at this and coined the term a pecking
order. This means that firms follow a set plan when raising capital.
If
they can they will use internally generated funds. However, if they
can
not do so, they will issue safe securities (those whose pricing is
more
immune from information asymmetries) before risky (those whose pricing
are
sensitive to informational differences). Thus, when a goes to the
public markets, the firm first tries to issue debt, then preferred
stock,
and finally as a last resort common stock. Investors follow this and
respond accordingly. (For example, “gee they are issuing common stock,
that must mean they can not issue debt, that must be bad news!)
You can think of this as a depth chart on a sports team. The announcement
of starting the third-string QB would likely worsen your odds of winning
just like the announcement that you are issuing stock will worsen your
stock price because it is assumed you can not sell your earlier choices.
This is consistent with the empirical evidence as firms first try to
use
internally generated funds then issue debt (roughly zero abnormal return)
and finally issue common stock (negative 3% abnormal return.)
For my class notes on capital structure:
http://www.financeprofessor.com/488/notes/capital_structure.htm
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