19-1
Chapter 19
The Capital Market
19-2
The Capital Market
? Public Issue
? Privileged Subscription
? Regulation of Security Offerings
? Private Placement
? Initial Financing
? Signaling Effects
? The Secondary Market
19-3
Capital Market
Capital Market -- The market for relatively
long-term (greater than one year original
maturity) financial instruments,
Primary Market -- A market where new
securities are bought and sold for the
first time (a new issues market).
Secondary Market -- A market for existing
(used) securities rather than new issues.
19-4
Capital Market
INVESTMENT SECTOR
FI
NA
NC
IA
L
IN
TER
MED
IA
RI
ES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
Public issue
Privileged
subscription
Private
placement
Indicates the possible
presence of a
standby arrangement
Indicates the financial
intermediaries?own
securities flow to the
savings sector
19-5
Public Issue
? Securities are sold to hundreds,and often
thousands,of investors under a formal
contract overseen by federal and state
regulatory authorities.
? When a company issues securities to the
general public,is usually uses the services
of an investment banker.
Public Issue -- Sale of bonds or stock
to the general public.
19-6
Investment Banker
? Investment banker receives an underwriting spread
when acting as a middleman in bringing together
providers and consumers of investment capital.
? Underwriting spread -- the difference between the
price the investment bankers pay for the security
and the price at which the security is resold to the
public.
Investment Banker -- A financial institution that
underwrites (purchases at a fixed price on a
fixed date) new securities for resale.
19-7
Investment Banker
? Thus,the services can be provided at a lower cost
to the firm than the firm can perform the same
services internally.
? Three primary means companies offer securities to
the general public:
?Traditional (firm commitment) underwriting
?Best efforts offering
?Shelf registration
? Investment bankers have expertise,contacts,and
the sales organization to efficiently market
securities to investors,
19-8
Traditional Underwriting
? If the security issue does not sell well,
either because of an adverse turn in the
market or because it is overpriced,the
underwriter,not the company,takes the
loss.
Underwriting -- Bearing the risk of not being
able to sell a security at the established
price by virtue of purchasing the security for
resale to the public; also known as firm
commitment underwriting.
19-9
Traditional Underwriting
A,Competitive-bid
? The issuing company specifies the date that
sealed bids will be received.
? Competing syndicates submit bids.
? The syndicate with the highest bid wins the
security issue.
Underwriting syndicate -- A temporary
combination of investment banking firms
formed to sell a new security issue.
19-10
Traditional Underwriting
? The issuing company selects an investment
banking firm and works directly with the firm to
determine the essential features of the issue.
? Together they discuss and negotiate a price for the
security and the timing of the issue.
? Depending on the size of the issue,the investment
banker may invite other firms to join in sharing the
risk and selling the issue.
? Generally used in corporate stock and most
corporate bond issues.
B,Negotiated offering
19-11
Traditional Underwriting
Best efforts offering -- A security offering in which
the investment bankers agree to use only their best
efforts to sell the issuer securities,The investment
bankers do not commit to purchase any unsold
securities.
Shelf registration -- A procedure whereby a company
is permitted to register securities it plans to sell over
the next two years; also called SEC Rule 415,These
securities can then be sold piecemeal whenever the
company chooses.
19-12
Shelf Registration,Flotation
Costs and Other Advantages
? This competition reduces underwriting spreads.
? The total fixed costs (legal and administrative) of
successive public debt issues are lower with a
single shelf registration than with a series of
traditional registrations.
? The amount of free advice available from
underwriters is less than before shelf registration
was an alternative to firms.
? A firm with securities sitting on the shelf can
require that investment banking firms
competitively bid for its underwriting business.
19-13
Privileged Subscription
Privileged subscription -- The sale of new securities
in which existing shareholders are given a
preference in purchasing these securities up to the
proportion of common shares that they already own;
also known as a rights offering.
Preemptive right -- The privilege of shareholders to
maintain their proportional company ownership by
purchasing a proportionate share of any new issue
of common stock,or securities convertible into
common stock.
19-14
Terms of Offering
Terms specify:
?the number of rights required to
subscribe for an additional share of stock
?the subscription price per share
?the expiration date of the offering
Right -- A short-term option to buy a certain
number (or fraction) of securities from the issuing
corporation; also called a subscription right.
19-15
Subscription Rights
Generally,the subscription period is three
weeks or less.
Options available to the holder of rights:
? Exercise the rights and subscribe for
additional shares
? Sell the rights (they are transferable)
? Do nothing and let the rights expire
19-16
Subscription Rights
The shareholder can then purchase 7 shares
(use 70 rights) and still retain the 7 remaining
rights,Thus,the shareholder needs to
purchase an additional 3 rights.
A shareholder who owns 77 shares and
just received 77 rights would like to
purchase 8 new shares,It takes 10 rights
for each new share,What action should
the shareholder take?
19-17
Value of Rights
A right allows you to buy new stock at a
discount that typically ranges between 10 to 20
percent from the current market price.
The market value of a right is a function of:
? the market price of the stock
? the subscription price
? the number of rights required to purchase an
additional share of stock
What gives a right its value?
19-18
P0 - R0 = [ (R0)(N) + S ],therefore
R0 = P0 - [ (R0)(N) + S ]
R0 = the market price of one right when the stock is
selling rights-on
P0 = the market price of a share of stock selling
rights-on
S = the subscription price per share
N = the number of rights required to purchase one
share of stock
How is the Value of
a Right Determined?
19-19
Solving for R0.
How is the Value of
a Right Determined?
P0 - S
N + 1R0 =
PX = P0 - R0 = [ (R0)(N) + S ]
By substitution for R0,we can solve the
ex-rights?value of one share of stock,PX,
(P0 )(N) + S
N + 1PX =
19-20
Example of the
Valuation of a Right
? Assume the following information:
? The current market price of a stock
rights-on is $50.
? The subscription price is $40.
? It takes nine rights to buy an
additional share of stock.
What is the value of a right when the stock is
selling rights-on? What is the value of one
share of stock when it goes ex-rights?
19-21
Solving for R0.
Solving for PX.
How is the Value of
a Right Determined?
$50 - $40
9 + 1R0 =
R0 = $1
($50 )(9) + $40
9 + 1PX =
PX = $49
19-22
Theoretical versus
Actual Value of Rights
? Transaction costs
? Speculation
? Irregular exercise and sale of rights
over the subscription period
Arbitrage acts to limit the deviation of
the actual right value from the
theoretical value.
Why might the actual value of a right
differ from its theoretical value?
19-23
Standby Arrangement
? Fee often composed of a flat fee and an additional
fee for each unsold share of stock.
? The greater the risk of an unsuccessful rights
offering,the more desirable a standby arrangement.
Standby Arrangement -- A measure taken to
ensure the complete success of a rights
offering in which an investment banker or
group of investment bankers agrees to stand
by to underwrite any unsubscribed (unsold)
portion of the issue.
19-24
Oversubscription Privilege
? For example,shareholders subscribe for 450,000
shares of a 500,000-share rights offering,Let us
assume that some shareholders would like more
shares and oversubscribe by 80,000 shares,
? As a result,each shareholder oversubscribing
receives 5/8ths (50,000 / 80,000) of a share for each
share oversubscribed.
Oversubscription privilege -- The right to
purchase,on a pro rata basis,any
unsubscribed shares in a rights offering.
19-25
Privileged Subscription
versus Underwritten Issue
? Investors are familiar with the firm’s operations
when using a rights offering.
? The principal sales tool is a discounted price
(rights offering) and the investment banking
organization (underwriting).
? A disadvantage of a rights offering is that the
shares will be sold at a lower price.
? There is greater dilution with a rights offering
which many firms attempt to avoid.
? There is a wider distribution of shares with a
public offering.
19-26
Regulation of Security
Offerings -- Federal
Securities Exchange Act of 1934 --
Regulates the secondary market for long-
term securities -- the securities exchanges
and the over-the-counter market.
Securities Act of 1933 -- Generally requires
that public offerings be registered with the
federal government before they may be
sold; also known as Truth in Securities Act.
Securities and Exchange Commission (SEC)
enforces both of these acts.
19-27
Regulation of Security
Offerings -- Federal
Part 1,Prospectus -- Discloses information
about the issuing company and its new
offering and is distributed to investors.
Part 2,Additional information required by the
SEC that is not part of the printed
prospectus.
Registration Statement -- The disclosure
document filed with the SEC in order to
register a new securities issue.
19-28
Red Herring
? SEC reviews the registration statement to see that
all the required information is presented and that it
is not misleading.
? Deficiencies are communicated in a comment letter.
? Once the SEC is satisfied,it approves the
registration,If not,it issues a stop order.
Red Herring -- The preliminary prospectus,It
includes a legend in red ink on the cover
stating that the registration statement has not
yet become effective.
19-29
Regulation of Security
Offerings -- Federal
?Registration statements become
effective on the 20th day after filing
(or on the 20th day after filing the last
amendment).
?The SEC,at its discretion,can
advance the date,Typical time from
filing to approval is 40 days.
Registration Statement Effective Date
19-30
Regulation of Security
Offerings -- Federal
? A shelf registration allows a company to
register with the SEC in advance of a
security offering.
? The company can sell off the shelf by filing a
simple amendment and having the SEC
accelerate the normal 20-day waiting period
accorded amendments.
? Typically,the waiting period following this
simple amendment is only a day or two.
Impact with shelf registration:
19-31
Regulation of Security
Offerings -- Federal
? The term reflects the stark,black-bordered
look of the ad (see slide 19-32).
? Includes the company’s name,a brief
description of the security,the offering
price,and the names of the investment
bankers in the underwriting syndicate.
Tombstone Advertisement -- An
announcement placed in newspapers and
magazines giving just the most basic details
of a security offering.
19-32
Regulation of Security
Offerings -- State
? Individual states have security commissions that
regulate securities in their states.
? These laws are particularly important when a
security issue is sold entirely to people within the
state and may not be subject to SEC regulation.
? Important if the SEC provides only limited review.
? States vary on the strictness of their regulation.
Blue Sky Laws -- State laws regulating the
offering and sale of securities.
19-33
Private Placement
? Eliminates the underwriting function of the
investment banker.
? The dominant private placement lender in this
group is the life-insurance category (pension
funds and bank trust departments are very
active as well).
Private (or Direct) Placement -- The sale of an
entire issue of securities (usually bonds)
directly to one purchaser or a small group of
purchasers (usually financial intermediaries).
19-34
Private
Placement Features
? Allows the firm to raise funds more quickly.
? Eliminates risks with respect to timing.
? Eliminates SEC regulation of the security.
? Terms can be tailored to meet the needs of
the borrower.
? Flexibility in borrowing smaller amounts
more frequently rather than a single large
amount.
19-35
Private Placement and
Recent Developments
? Qualified Institutional Buyers (QIBs) --
Eligible purchasers,by SEC Rule 144a,of
previous securities from a private
placement without having to go through a
public market registration.
? Event Risk -- The risk that existing debt
will suffer a decline in creditworthiness
because of the issuance of additional debt
securities,usually in connection with
corporate restructuring.
19-36
Initial Financing --
Venture Capital
? Wealthy investors and financial institutions are the
primary providers of funds for a new enterprise
(usually common stock).
? Rule 144 and the 1933 Act requires privately placed
securities to be held for at least two years or be
registered before they can be resold,
? Letter stock * -- Privately placed common stock that
cannot be immediately resold.
* Note,Under SEC Rule 144a,however,letter stock could
be sold to qualified institutional buyers (QIBs) without a
waiting period.
19-37
Initial Public Offering (IPO) -- A company’s first
offering of common stock to the general public
Initial Financing --
Initial Public Offerings
? Often prompted by venture capitalists who
wish to realize a cash return on their
investment.
? Founders of the firm may wish to go through
an IPO to establish a value for their company.
? There exists greater price uncertainty with an
IPO than with other new public stock issues.
19-38
Signaling Effects
?Negative stock
price reaction to
common stock or
convertible
issues.
?Straight debt and
preferred stock
do not tend to
show statistically
significant
effects,-10 -8 -6 -4 -2 0 2 4 6 8
0
-1
-2
-3
-4
3
2
1
Cu
mu
lati
ve
Av
er
ag
e
Ab
no
rm
al
Re
tu
rn
(%
)
Time Around Announcement (in days)
Relative Abnormal
Stock Returns for a
New Equity Issue
19-39
Possible Explanations
for Price Reactions
Asymmetric (Unequal) Information
?Potential investors have less information than
management (particularly for common stock).
?Exchanges of different types of securities show that
increases (decreases) in financial leverage are
associated with positive (negative) abnormal returns.
Expectations of Future Cash Flows
?The unexpected sale of securities may be associated
with lower than expected operating cash flows and
interpreted as bad news,Hence,the stock price
might suffer accordingly.
19-40
The Secondary Market
? Purchases and sales of existing stocks and bonds
occur in the secondary market.
? Transactions in the secondary market do not provide
additional funds to the firm.
? The secondary market increases the liquidity of
securities outstanding and lowers the required
returns of investors.
? Composed of organized exchanges like the New York
Stock Exchange and American Stock Exchange plus
the over-the-counter (OTC) market.
Chapter 19
The Capital Market
19-2
The Capital Market
? Public Issue
? Privileged Subscription
? Regulation of Security Offerings
? Private Placement
? Initial Financing
? Signaling Effects
? The Secondary Market
19-3
Capital Market
Capital Market -- The market for relatively
long-term (greater than one year original
maturity) financial instruments,
Primary Market -- A market where new
securities are bought and sold for the
first time (a new issues market).
Secondary Market -- A market for existing
(used) securities rather than new issues.
19-4
Capital Market
INVESTMENT SECTOR
FI
NA
NC
IA
L
IN
TER
MED
IA
RI
ES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
Public issue
Privileged
subscription
Private
placement
Indicates the possible
presence of a
standby arrangement
Indicates the financial
intermediaries?own
securities flow to the
savings sector
19-5
Public Issue
? Securities are sold to hundreds,and often
thousands,of investors under a formal
contract overseen by federal and state
regulatory authorities.
? When a company issues securities to the
general public,is usually uses the services
of an investment banker.
Public Issue -- Sale of bonds or stock
to the general public.
19-6
Investment Banker
? Investment banker receives an underwriting spread
when acting as a middleman in bringing together
providers and consumers of investment capital.
? Underwriting spread -- the difference between the
price the investment bankers pay for the security
and the price at which the security is resold to the
public.
Investment Banker -- A financial institution that
underwrites (purchases at a fixed price on a
fixed date) new securities for resale.
19-7
Investment Banker
? Thus,the services can be provided at a lower cost
to the firm than the firm can perform the same
services internally.
? Three primary means companies offer securities to
the general public:
?Traditional (firm commitment) underwriting
?Best efforts offering
?Shelf registration
? Investment bankers have expertise,contacts,and
the sales organization to efficiently market
securities to investors,
19-8
Traditional Underwriting
? If the security issue does not sell well,
either because of an adverse turn in the
market or because it is overpriced,the
underwriter,not the company,takes the
loss.
Underwriting -- Bearing the risk of not being
able to sell a security at the established
price by virtue of purchasing the security for
resale to the public; also known as firm
commitment underwriting.
19-9
Traditional Underwriting
A,Competitive-bid
? The issuing company specifies the date that
sealed bids will be received.
? Competing syndicates submit bids.
? The syndicate with the highest bid wins the
security issue.
Underwriting syndicate -- A temporary
combination of investment banking firms
formed to sell a new security issue.
19-10
Traditional Underwriting
? The issuing company selects an investment
banking firm and works directly with the firm to
determine the essential features of the issue.
? Together they discuss and negotiate a price for the
security and the timing of the issue.
? Depending on the size of the issue,the investment
banker may invite other firms to join in sharing the
risk and selling the issue.
? Generally used in corporate stock and most
corporate bond issues.
B,Negotiated offering
19-11
Traditional Underwriting
Best efforts offering -- A security offering in which
the investment bankers agree to use only their best
efforts to sell the issuer securities,The investment
bankers do not commit to purchase any unsold
securities.
Shelf registration -- A procedure whereby a company
is permitted to register securities it plans to sell over
the next two years; also called SEC Rule 415,These
securities can then be sold piecemeal whenever the
company chooses.
19-12
Shelf Registration,Flotation
Costs and Other Advantages
? This competition reduces underwriting spreads.
? The total fixed costs (legal and administrative) of
successive public debt issues are lower with a
single shelf registration than with a series of
traditional registrations.
? The amount of free advice available from
underwriters is less than before shelf registration
was an alternative to firms.
? A firm with securities sitting on the shelf can
require that investment banking firms
competitively bid for its underwriting business.
19-13
Privileged Subscription
Privileged subscription -- The sale of new securities
in which existing shareholders are given a
preference in purchasing these securities up to the
proportion of common shares that they already own;
also known as a rights offering.
Preemptive right -- The privilege of shareholders to
maintain their proportional company ownership by
purchasing a proportionate share of any new issue
of common stock,or securities convertible into
common stock.
19-14
Terms of Offering
Terms specify:
?the number of rights required to
subscribe for an additional share of stock
?the subscription price per share
?the expiration date of the offering
Right -- A short-term option to buy a certain
number (or fraction) of securities from the issuing
corporation; also called a subscription right.
19-15
Subscription Rights
Generally,the subscription period is three
weeks or less.
Options available to the holder of rights:
? Exercise the rights and subscribe for
additional shares
? Sell the rights (they are transferable)
? Do nothing and let the rights expire
19-16
Subscription Rights
The shareholder can then purchase 7 shares
(use 70 rights) and still retain the 7 remaining
rights,Thus,the shareholder needs to
purchase an additional 3 rights.
A shareholder who owns 77 shares and
just received 77 rights would like to
purchase 8 new shares,It takes 10 rights
for each new share,What action should
the shareholder take?
19-17
Value of Rights
A right allows you to buy new stock at a
discount that typically ranges between 10 to 20
percent from the current market price.
The market value of a right is a function of:
? the market price of the stock
? the subscription price
? the number of rights required to purchase an
additional share of stock
What gives a right its value?
19-18
P0 - R0 = [ (R0)(N) + S ],therefore
R0 = P0 - [ (R0)(N) + S ]
R0 = the market price of one right when the stock is
selling rights-on
P0 = the market price of a share of stock selling
rights-on
S = the subscription price per share
N = the number of rights required to purchase one
share of stock
How is the Value of
a Right Determined?
19-19
Solving for R0.
How is the Value of
a Right Determined?
P0 - S
N + 1R0 =
PX = P0 - R0 = [ (R0)(N) + S ]
By substitution for R0,we can solve the
ex-rights?value of one share of stock,PX,
(P0 )(N) + S
N + 1PX =
19-20
Example of the
Valuation of a Right
? Assume the following information:
? The current market price of a stock
rights-on is $50.
? The subscription price is $40.
? It takes nine rights to buy an
additional share of stock.
What is the value of a right when the stock is
selling rights-on? What is the value of one
share of stock when it goes ex-rights?
19-21
Solving for R0.
Solving for PX.
How is the Value of
a Right Determined?
$50 - $40
9 + 1R0 =
R0 = $1
($50 )(9) + $40
9 + 1PX =
PX = $49
19-22
Theoretical versus
Actual Value of Rights
? Transaction costs
? Speculation
? Irregular exercise and sale of rights
over the subscription period
Arbitrage acts to limit the deviation of
the actual right value from the
theoretical value.
Why might the actual value of a right
differ from its theoretical value?
19-23
Standby Arrangement
? Fee often composed of a flat fee and an additional
fee for each unsold share of stock.
? The greater the risk of an unsuccessful rights
offering,the more desirable a standby arrangement.
Standby Arrangement -- A measure taken to
ensure the complete success of a rights
offering in which an investment banker or
group of investment bankers agrees to stand
by to underwrite any unsubscribed (unsold)
portion of the issue.
19-24
Oversubscription Privilege
? For example,shareholders subscribe for 450,000
shares of a 500,000-share rights offering,Let us
assume that some shareholders would like more
shares and oversubscribe by 80,000 shares,
? As a result,each shareholder oversubscribing
receives 5/8ths (50,000 / 80,000) of a share for each
share oversubscribed.
Oversubscription privilege -- The right to
purchase,on a pro rata basis,any
unsubscribed shares in a rights offering.
19-25
Privileged Subscription
versus Underwritten Issue
? Investors are familiar with the firm’s operations
when using a rights offering.
? The principal sales tool is a discounted price
(rights offering) and the investment banking
organization (underwriting).
? A disadvantage of a rights offering is that the
shares will be sold at a lower price.
? There is greater dilution with a rights offering
which many firms attempt to avoid.
? There is a wider distribution of shares with a
public offering.
19-26
Regulation of Security
Offerings -- Federal
Securities Exchange Act of 1934 --
Regulates the secondary market for long-
term securities -- the securities exchanges
and the over-the-counter market.
Securities Act of 1933 -- Generally requires
that public offerings be registered with the
federal government before they may be
sold; also known as Truth in Securities Act.
Securities and Exchange Commission (SEC)
enforces both of these acts.
19-27
Regulation of Security
Offerings -- Federal
Part 1,Prospectus -- Discloses information
about the issuing company and its new
offering and is distributed to investors.
Part 2,Additional information required by the
SEC that is not part of the printed
prospectus.
Registration Statement -- The disclosure
document filed with the SEC in order to
register a new securities issue.
19-28
Red Herring
? SEC reviews the registration statement to see that
all the required information is presented and that it
is not misleading.
? Deficiencies are communicated in a comment letter.
? Once the SEC is satisfied,it approves the
registration,If not,it issues a stop order.
Red Herring -- The preliminary prospectus,It
includes a legend in red ink on the cover
stating that the registration statement has not
yet become effective.
19-29
Regulation of Security
Offerings -- Federal
?Registration statements become
effective on the 20th day after filing
(or on the 20th day after filing the last
amendment).
?The SEC,at its discretion,can
advance the date,Typical time from
filing to approval is 40 days.
Registration Statement Effective Date
19-30
Regulation of Security
Offerings -- Federal
? A shelf registration allows a company to
register with the SEC in advance of a
security offering.
? The company can sell off the shelf by filing a
simple amendment and having the SEC
accelerate the normal 20-day waiting period
accorded amendments.
? Typically,the waiting period following this
simple amendment is only a day or two.
Impact with shelf registration:
19-31
Regulation of Security
Offerings -- Federal
? The term reflects the stark,black-bordered
look of the ad (see slide 19-32).
? Includes the company’s name,a brief
description of the security,the offering
price,and the names of the investment
bankers in the underwriting syndicate.
Tombstone Advertisement -- An
announcement placed in newspapers and
magazines giving just the most basic details
of a security offering.
19-32
Regulation of Security
Offerings -- State
? Individual states have security commissions that
regulate securities in their states.
? These laws are particularly important when a
security issue is sold entirely to people within the
state and may not be subject to SEC regulation.
? Important if the SEC provides only limited review.
? States vary on the strictness of their regulation.
Blue Sky Laws -- State laws regulating the
offering and sale of securities.
19-33
Private Placement
? Eliminates the underwriting function of the
investment banker.
? The dominant private placement lender in this
group is the life-insurance category (pension
funds and bank trust departments are very
active as well).
Private (or Direct) Placement -- The sale of an
entire issue of securities (usually bonds)
directly to one purchaser or a small group of
purchasers (usually financial intermediaries).
19-34
Private
Placement Features
? Allows the firm to raise funds more quickly.
? Eliminates risks with respect to timing.
? Eliminates SEC regulation of the security.
? Terms can be tailored to meet the needs of
the borrower.
? Flexibility in borrowing smaller amounts
more frequently rather than a single large
amount.
19-35
Private Placement and
Recent Developments
? Qualified Institutional Buyers (QIBs) --
Eligible purchasers,by SEC Rule 144a,of
previous securities from a private
placement without having to go through a
public market registration.
? Event Risk -- The risk that existing debt
will suffer a decline in creditworthiness
because of the issuance of additional debt
securities,usually in connection with
corporate restructuring.
19-36
Initial Financing --
Venture Capital
? Wealthy investors and financial institutions are the
primary providers of funds for a new enterprise
(usually common stock).
? Rule 144 and the 1933 Act requires privately placed
securities to be held for at least two years or be
registered before they can be resold,
? Letter stock * -- Privately placed common stock that
cannot be immediately resold.
* Note,Under SEC Rule 144a,however,letter stock could
be sold to qualified institutional buyers (QIBs) without a
waiting period.
19-37
Initial Public Offering (IPO) -- A company’s first
offering of common stock to the general public
Initial Financing --
Initial Public Offerings
? Often prompted by venture capitalists who
wish to realize a cash return on their
investment.
? Founders of the firm may wish to go through
an IPO to establish a value for their company.
? There exists greater price uncertainty with an
IPO than with other new public stock issues.
19-38
Signaling Effects
?Negative stock
price reaction to
common stock or
convertible
issues.
?Straight debt and
preferred stock
do not tend to
show statistically
significant
effects,-10 -8 -6 -4 -2 0 2 4 6 8
0
-1
-2
-3
-4
3
2
1
Cu
mu
lati
ve
Av
er
ag
e
Ab
no
rm
al
Re
tu
rn
(%
)
Time Around Announcement (in days)
Relative Abnormal
Stock Returns for a
New Equity Issue
19-39
Possible Explanations
for Price Reactions
Asymmetric (Unequal) Information
?Potential investors have less information than
management (particularly for common stock).
?Exchanges of different types of securities show that
increases (decreases) in financial leverage are
associated with positive (negative) abnormal returns.
Expectations of Future Cash Flows
?The unexpected sale of securities may be associated
with lower than expected operating cash flows and
interpreted as bad news,Hence,the stock price
might suffer accordingly.
19-40
The Secondary Market
? Purchases and sales of existing stocks and bonds
occur in the secondary market.
? Transactions in the secondary market do not provide
additional funds to the firm.
? The secondary market increases the liquidity of
securities outstanding and lowers the required
returns of investors.
? Composed of organized exchanges like the New York
Stock Exchange and American Stock Exchange plus
the over-the-counter (OTC) market.
