Chapter 15 How Corporations Issue Securities 397
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◗ FIGURE 15.5 Total direct costs as a percentage of gross proceeds. The total direct costs
for initial public offerings (IPOs), seasoned equity offerings (SEOs), convertible bonds, and straight
bonds are composed of underwriter spreads and other direct expenses.
Source: SDC Platinum.
Notes: There were 5706 domestic issues between 2004 and 2008. Closed-end funds (SIC 6726), REITS (SIC 6798), ADRs, mortgage-
backed and federal agency (SIC 6011, 6019, 6111 and 999B) issues are excluded.0123456789Total direct costs, %Less than 250250−600 600−1,000
1,000−1,5001,500−2,0002,000−2,5002,500−3,0003,000 and up
Proceeds, $ millionsIPOs
SEOsConvertibles
BondsThe CFO could scale back or delay the expansion until the company’s stock price recovers.
That too is costly, but it may be rational if the stock price is severely undervalued and a stock
issue is the only source of financing.
If a CFO knows that the company’s stock is overvalued, the position is reversed. If the firm
sells new shares at the high price, it will help existing shareholders at the expense of the new
ones. Managers might be prepared to issue stock even if the new cash is just put in the bank.
Of course, investors are not stupid. They can predict that managers are more likely to issue
stock when they think it is overvalued and that optimistic managers may cancel or defer issues.
Therefore, when an equity issue is announced, they mark down the price of the stock accord-
ingly. Thus the decline in the price of the stock at the time of the new issue may have nothing
to do with the increased supply but simply with the information that the issue provides.^39
Cornett and Tehranian devised a natural experiment that pretty much proves this point.^40
They examined a sample of stock issues by commercial banks. Some of these issues were nec-
essary to meet capital standards set by banking regulators. The rest were ordinary, voluntary
stock issues designed to raise money for various corporate purposes. The necessary issues
caused a much smaller drop in stock prices than the voluntary ones, which makes perfect
sense. If the issue is outside the manager’s discretion, announcement of the issue conveys no
information about the manager’s view of the company’s prospects.^41
(^39) This explanation was developed in S. C. Myers and N. S. Majluf, “Corporate Financing and Investment Decisions When Firms Have
Information That Investors Do Not Have,” Journal of Financial Economics 35 (1998), pp. 99–122.
(^40) M. M. Cornett and H. Tehranian, “An Examination of Voluntary versus Involuntary Issuances by Commercial Banks,” Journal of
Financial Economics 35 (1994), pp. 99–122.
(^41) The “involuntary issuers” did make a choice: They could have forgone the stock issue and run the risk of failing to meet the regula-
tory capital standards. The banks that were more concerned with this risk were more likely to issue. Thus it is no surprise that Cornett
and Tehranian found some drop in stock price even for the involuntary issues.