Ch. 6: Security Offerings 331
The model ofLucas and McDonald (1990)departs from other models of adverse
selection in that they allow the firm’s investment opportunity to be postponed. This
gives undervalued firms an incentive to postpone an issue until the stock price is higher
relative to the manager’s valuation based on proprietary information. This implies that
empirically we should obverse more equity issues following bull markets.
Projects that can be postponed as the firm waits for more favorable market conditions
to issue equity can be viewed as real options.Carlson, Fisher, and Giammarino (2005,
2006)present a real option model with rational agents that can explain the stock price
dynamics around seasoned equity offerings. We discuss these models in more detail
below.
5.1.1. Adverse selection and the business cycle
InChoe, Masulis, and Nanda (1993), an adverse selection argument similar toMyers
and Majluf (1984)is developed where firms choose between issuing debt and equity
across business cycle expansions and contractions, where firms receive non-deferrable
profitable investment opportunities, and they must issue debt or equity securities to
pursue them.^42 If a firm issues debt, investors will demand either protective covenants
or a price discount for anticipated asset substitution risk once the debt is issued. This
imposes a debt issuance cost on all issuers. On the other hand, firms with undervalued
equity will only issue equity when the dilution cost from selling undervalued stock is
less than or equal to the debt issuance cost.^43 In the aggregate, the marginal equity issuer
will find the dilution cost of issuing undervalued equity is just equal to the cost of debt
issuance and will be indifferent to issuing debt or equity. All other firms will find that
one of the two securities will dominate due to their lower issuance costs. Also, if a firm
issues equity, then the market knows that the equity was not substantially underpriced,
because if it was the firm would have issued debt. Thus, an equity announcement should
be greeted with a negative price reaction because investors now know that the firms
issuing equity are drawn from a less desirable distribution that is truncated from above
and the opposite is true for firms issuing debt.
Choe, Masulis, and Nanda observe that corporate investment opportunities are typi-
cally more profitable in periods of economic expansions than during contractions. This
can reduce the dilution effect of equity issuance, though the cost of debt issuance is rel-
atively insensitive to the point in the business cycle when an offer occurs. In economic
expansions it is common knowledge that the average firm issuing equity will be more
profitable and the marginal equity issuer will need to be more underpriced ex ante, if its
equity dilution effect is to equate to the debt issuance cost. In addition, all less under-
priced firms will prefer to issue equity. Thus, fewer firms will choose to issue debt over
(^42) Parts of this section are drawn fromEckbo and Masulis (1995).
(^43) The dilution cost of issuing equity is assumed to be more than offset by the profits of the investment
opportunity or else no investment would take place.