332 B.E. Eckbo et al.
equity. As more profitable and more underpriced firms find it optimal to equity finance,
the equity offer announcement effect (the adverse selection effect for the average equity
issuer) is reduced, lowering the issuance cost of equity. Thus in economic expansions,
the model predicts a smaller equity offer announcement effect and an rise in the relative
frequency of equity offers.^44
Consistent with the prior prediction, bothMoore (1980)andChoe, Masulis, and
Nanda (1993)find empirical evidence that the frequency of equity offers relative to
debt offers rises in expansions, while at the same time the magnitude of the negative
stock price reaction to firm commitment equity offer announcements decreases. In con-
trast, debt issues are insensitive to this equity issue mispricing effect. The evidence in
Choe, Masulis, and Nanda (1993), Marsh (1982)andTaggart (1977)indicates that the
number of straight debt offers does not fall in economic contractions and may in fact
rise if interest rates also fall with the contraction. This latter effect may in part reflect
debt refinancing activities in these periods.
The model ofChoe, Masulis, and Nanda (1993)also predicts that the adverse selec-
tion effect increases as investor uncertainty concerning the value of assets in place rises.
Schwert (1989)documents that stock price volatility varies over the business cycle,
increasing during recessions.^45 Controlling for the effect of the business cycle,Choe,
Masulis, and Nanda (1993)find that the relative frequency of equity issues is signifi-
cantly negatively related to the issuer’s daily stock return variance, which gives further
empirical support to their adverse selection framework.
Several other hypotheses concerning the timing of equity offers can be extended to a
business cycle environment. For example, underMyers (1984)’s pecking order hypoth-
esis, firms are viewed as preferring to finance projects internally if possible, otherwise
to issue low risk debt and to issue equity only as a last resort. Imposing an arbitrary
limit on firm leverage, the timing of equity issues is affected by business cycle down-
turns that reduce internal sources of funds and raise leverage by lowering asset values,
thereby making equity offers more attractive. However, this equity issuance scenario is
inconsistent with the evidence found inChoe, Masulis, and Nanda (1993).
Another hypothesis is based on debt-equity wealth transfers predicted byGalai and
Masulis (1976)andJensen and Meckling (1976)to occur when leverage is unexpectedly
revised. If a firm issues equity, thus lowering its leverage, debtholders gain since their
risk premium continues to be paid in full, while their risk bearing falls. This tends to dis-
courage management seeking to maximize shareholder wealth from undertaking equity
offers, except when leverage has become unacceptably high. In economic contractions,
debtholders bear greater risk and expect greater risk premiums. So in downturns, equity
offers cause leverage to fall more, resulting in larger reductions in debt risk-bearing and
(^44) If less profitable investment projects or projects with varying profitability are assumed, then the model
predicts in economic expansions that fewer undervalued firms will forego equity financing because of their
project’s greater profitability.
(^45) Schwert links this volatility increase to increases in operating leverage, which is likely to be positively
related to investor uncertainty concerning the value of assets in place.