312 B.E. Eckbo et al.
The following numerical example illustrates a positive issue surprise effect by simply
adding the shareholder takeup parameterkto the originalMyers and Majluf (1984)
model. Suppose the market does not knowkex ante, but believes thatk=0. Moreover,
it is common knowledge that the firm’s assets in placeamay be in one of two equally
likely states: “high” witha=$150 or “low” witha=50. In both states, the project
NPV isb=20. Withk=0 (which means we are back in the Myers–Majluf model), it
follows that the firm in this example will only issue if it is in the low state.^32 This implies
a pre-issue stock pricep−which reflects an underinvestment discount (capitalizing the
value of the project only in the low state):p−=( 150 × 0. 5 +( 50 + 20 )× 0. 5 )=$110.
If the firm announces a stock issue and revealsk=0, the post-issue price will be
p+=( 50 + 20 )=$70. In this case, the firm sells the fraction( 100 / 210 )× 100 =48%
of the firm in order to raise $100, generating a market reaction ofAR= 100 ×( 70 −
110 )/ 110 =−36%.
However, suppose the issuer surprises the market by revealingk=1 through the
offering process. Sincek=1 implies that the firm prefers to issue in both states (there
is no wealth transfer to outside investors), there is pooling and the issue announcement
carries no information about the true state. Still, the announcement causes the market
to eliminate the underinvestment discount, now capitalizing the value of the project in
bothstates:p+=$120 andAR=9%. In this example, new information revealing a
high value ofkreverses market expectations from a separating equilibrium to a pooling
equilibrium, resulting inAR>0.
It is clear from the above that the implied market reaction to issue announcements
may be negative, zero, or positive in information settings that represent simple refine-
ments of the originalMyers and Majluf (1984)setup—even when preserving their single
flotation method environment. We next describe predictions emanating from models al-
lowing for a choice between several flotation methods.
4.3.2. Modelling the flotation method choice
In the first model of the flotation method choice,Heinkel and Schwartz (1986)allow
issuers to choose between uninsured rights, standby rights and ‘firm commitment’ of-
ferings. In their model, uninsured rights carry a risk of offering failure, while standby
rights and firm commitment offers fully guarantee the offering proceeds. The standby
underwriter fully reveals the issuer type while the firm commitment underwriter is un-
informed. In equilibrium, the highest-valued issuers select standbys, intermediate-value
issuer select uninsured rights, while the lowest-valued issuers select firm commitment
offers. Thus, this model predictsARfc<ARur<0 andARsr>0.
In theHeinkel and Schwartz (1986)model, the quality certification in a standby rights
offer makes this a more expensive flotation method than firm commitment offerings,
(^32) Note thatk=0 still means that the firm could put on a fully subscribed rights offer. However, in such a
rights offer, every subscriber would be a new shareholder.