330 B.E. Eckbo et al.
- Security offerings and market timing
Consider a company that faces a steady stream of new projects. In the standard corpo-
rate finance textbook, projects are executed if they have a positive net present value.
If the owner of the project needs external financing, capital markets will provide the
needed funds and the type of security has no effect on the project’s value. In this setting,
there is no room for timing a security offering. However,Graham and Harvey (2001)
present survey evidence that suggests that managers are concerned about the appro-
priate timing of equity issues. Moreover, the stylized facts concerning the stock price
dynamics around SEOs (a stock price runup prior to the issue, a negative market reac-
tion to the announcement of the issue, and long-run returns that appear low compared
to similar firms) seems to indicate that managers are timing these issues around periods
of temporary overvaluation.
This section reviews various models that focus on explaining the timing of seasoned
equity offerings. Prior to the mid 1990s, the low long-run stock returns were not com-
monly known. Thus, papers written prior to this period focused on explaining the stock
price runup and the negative average announcement effect. Later models also had to ex-
plain post-issue stock price performance patterns. We discuss three classes of models:
one based on rational market pricing, another with some non-rational agents, and finally
a statistical model of “pseudo-timing”.
5.1. Timing theories with rational market pricing
As discussed in Section4, information asymmetry between managers and investors
may create an incentive for managers to time an equity issue. Some undervalued firms
will forgo profitable projects because the dilution costs of issuing undervalued equity
borne by existing shareholders are too high relative to the project’s profitability. Other
undervalued firms will only issue if the project can be financed with debt.Myers (1984)
builds on this insight and suggests that there is a financing choice pecking order in
which firms only use equity as a last resort.
Korajczyk, Lucas, and McDonald (1992)andChoe, Masulis, and Nanda (1993)de-
velop models of dynamic adverse selection that imply a relationship between equity
issue activity and, respectively, firm specific information releases and the business cycle.
The model ofKorajczyk, Lucas, and McDonald (1992)predicts clustering of equity is-
sues after information releases (especially quarterly and annual financial reports).Choe,
Masulis, and Nanda (1993)observe that during periods of economic expansions, corpo-
rate investment opportunities are more profitable, and thus, adverse selection costs are
lower. In these models, managers time the sale of equity offers to periods when infor-
mation asymmetries are less severe.Bayless and Chaplinsky (1996)report that equity
issues tend to cluster in periods with smaller average announcement effects. They inter-
pret this pattern as evidence that issuers timing equity offerings to periods with lower
levels of asymmetric information.