Ch. 6: Security Offerings 305
Eckbo and Masulis (1992)generalize the Myers–Majluf framework by explicitly al-
lowing current shareholder participation in the issue via a rights offer. Moreover, they
introduce noisy but informative quality certification in the form of underwriting (stand-
bys or firm commitment contracts). These refinements allow a realistic representation
of the most commonly used flotation methods, and they result in a number of interesting
predictions not available fromMyers and Majluf (1984). In particular, as discussed in
more detail in the subsequent section, the set of circumstances in which one expects a
negative market reaction to equity issue announcements is considerably smaller.
To illustrate the shareholder takeup model, letk∈[ 1 , 0 ]denote the exogenously
given and observable fraction of the issue that is taken up by current shareholders.^26
Moreover, letC(k)denote total issue costs, which is the sum of direct costsdand ex-
pected wealth transfer to outside investors. As inEckbo and Norli (2004), the expected
profitsπfrom issuing and investing can be written
π=b−C(k)=b−d− (1)I( 1 −k)[(a+b+I−d)−P]
P,
whereP is the post-issue secondary market price of the issuer.P is determined by
investors’ equilibrium beliefs abouta. In a separating equilibrium,Pequals the full-
information value of the post-issue company (P=a+b+I−d), with issue profits of
π=b−d. In a pooling equilibrium, however, undervalued firms experience a positive
wealth transfer asP<a+b+I−d.^27
Equation(1)shows how the magnitude of any wealth transfer cost is attenuated by
shareholder takeupk. Essentially, shareholder takeup acts like a form of financial slack.
Ifk=1,π=b−dand the wealth transfer cost is zero, even if the market undervalues
the stock (P<a+b+I−d). Ifk<1, which means that some shareholders in
a rights offer will sell their rights to outside investors rather than subscribe, adverse
selection costs are positive for undervalued firmseven if the rights offer is expected to
be fully subscribed in the end. If the firm uses an uninsured rights offer whenk=0,
current shareholders sellallthe rights, and the entire issue is sold to outside investors.
This is a worst-case scenario in terms of wealth-transfer costs: since there is no quality
certification, uninsured rights generate the same potential for wealth transfers associated
with the direct offer mechanism inMyers and Majluf (1984).
Eckbo and Masulis (1992)argue that their shareholder takeup model resolves the
rights offer paradox: high-quality issuers gravitate towards flotation methods that mini-
mize the potential for wealth transfer costs. Their key insight is to show that the wealth
(^26) Because the fractionkreflects individual shareholder wealth constraints, it is in part exogenous to the
firm.kis observable through subscription precommitments (published in the issue prospectus), and through
the rights trading activity (trades occur when current shareholder do not want to participate).
(^27) As discussed inEckbo and Norli (2004), the profit function in equation(1)presumes that the offering
priceP 0 is set consistent with market beliefsP 0 =P. Thus, this function ignores the possibility of using an
offering price discount to convey information. We return to the offering discount below.