Ch. 6: Security Offerings 261
rights offerings and direct purchase plans.Fama and French (2005)document that under
their measure of equity issues, equity offerings are commonplace. For the three ten-
year periods between 1973–2002 the authors find that 54%, 62%, and 72% of sample
firms make net equity issuesevery year. They interpret this finding as a violation of the
pecking order theory.
However, it is not clear that the evidence inFama and French (2005), or studies of
theShyam-Sunder and Myers (1999)type of financing deficit, have the requisite power
to reject the (basic) pecking order theory. Recall that this theory requires asymmetric
information between the issuer and the investor purchasing the issue. A large proportion
of the equity issues identified byFama and French (2005)are stock swaps in mergers
and acquisitions as well as stocks issued as part of employee compensation plans. It
is difficult to imagine that stocks issued to CEOs give rise to adverse selection costs.
Moreover, the ample opportunities for information exchange during merger negotiations
also reduce adverse selection costs driven by information asymmetries. Also, given the
two-sidedinformation asymmetry associated with a stock exchange merger (the true
value of the target shares is unknown to the bidder and vice versa), there is theoretical
support for the proposition that the bidder prefers equity over cash or debt as the form of
payment (seeEckbo, Giammarino, and Heinkel (1990)and the survey byBetton, Eckbo,
and Thorburn (2007)). In sum, absent the requisite one-sided information asymmetry
depicted in the original paper ofMyers and Majluf (1984), evidence on the frequency
of equity issues per se may have little power to test the pecking order. Of course, an
equity issue for cashdoessatisfy this particular information asymmetry requirement
since the value of cash is known to both sides of the transaction. As shown byEckbo
and Norli (2006)(Table 5above), external equity issues for cash are indeed rare. This
is consistent with the presence of external financing costs emanating from asymmetric
information—as emphasized under the pecking order theory.
- Flotation costs
To the extent that corporations choose among alternative financing methods so as to
maximize the expected net proceeds of security offerings, flotation costs can have a
large bearing on the choices an issuer makes. Broadly speaking, expected flotation costs
includes components such as the expected issue announcement effect, expected under-
pricing, underwriter spread, expected out of pocket expenses, the probability of offer
cancellation multiplied by the expected cost of cancellation,^15 and any short term in-
cremental costs or benefits (if any) of moving away or towards a firm’s target leverage
ratio.
There is some disagreement on whether a security announcement is an expected flota-
tion cost. Some researchers argue that a security offering announcement effect simply
(^15) The expected cost of offer cancellation includes the loss of out of pocket expenses, management time and
the expected opportunity costs of forgoing profitable investment projects if the offering isn’t resurrected later.