334 B.E. Eckbo et al.
Another hypothesis that predicts variation in the relative frequency of equity and
debt offers over the business cycle is the belief of many practitioners that management
prefers debt issuance when interest rates are historically low and prefers to issue stock
when its price is historically high, regardless of whether this is caused by relatively low
equity risk premiums or relatively high expected cash flows.^46 Since stock market prices
tend to reflect future economic prospects, this hypothesis tends to predict increases in
equity offers in economic expansions, when equity prices are relatively high and debt
issues in economic contractions, when interest rates are also low.^47 These predictions
are consistent with the evidence inMarsh (1982)andTaggart (1977), but only partially
consistent with the evidence inChoe, Masulis, and Nanda (1993).
Bayless and Chaplinsky (1991)explore the effects of both firm-specific and macro-
economic variables on the security issue choice. The macroeconomic variables include
the prior 3 month performance of the stock market (S&P 500), 3 month change in the
Treasury bill interest rate and a corporate default premium. They find larger announce-
ment effects when a security that is not expected is issued.Korajczyk and Levy (2003)
also explore the effects of macroeconomic conditions and financial constraints on the se-
curity issue choice. They report that financially unconstrained firms act in a significantly
different manner from financially constrained firms, which are defined as firms not pay-
ing cash dividends, not making net equity or debt repurchases and having a market to
book ratio of greater than one. The lagged macroeconomic variables that they examine
are: the term spread, the default spread and a three month equity market return. They
find that unconstrained firms issue activity is significantly affected by macroeconomic
variables, while for constrained firms, this is not the case, except for the lagged stock
market return. They also find that equity issuance is more likely when the lagged three
month average of two-day SEO announcement returns is less negative and when the is-
suer’s prior one year abnormal stock returns is higher. Korajczyk and Levy also estimate
firm target leverage and then use deviations from it as another explanatory variable for
the security issue choice decision and find that a leverage deficit leads to a significant
increase in debt issuance. Lastly, they report that target leverage is counter-cyclical for
the unconstrained firms, while it is pro-cyclical for the constrained firms. Their results
suggest that researchers should be concerned with whether an issuing firm is financially
constrained or not and they should also consider including macroeconomic variables as
controls in their analysis of offering announcement effects.
5.1.2. Optimal investments and equity offerings
As pointed out byCarlson, Fisher, and Giammarino (2005, 2006), it is commonly
assumed that investments in risky projects will increase asset risk. Moreover, this as-
sumption is difficult to square with the observation that post SEO long-run stock returns
(^46) See, for example, the survey of CFOs byGraham and Harvey (2001).
(^47) This equity issuance effect can also be reinforced when warrants and convertible securities are outstanding,
since a rise in the stock price can push these options into-the-money and also make conversion forcing calls
attractive for many firms.