Ch. 6: Security Offerings 337
do not fully incorporate managerial incentives to time equity issues. This results in
initial overpricing of issuing firms and a subsequent long-run underperformance when
investors correct this initial mispricing over time.
The overconfidence hypothesis ofDaniel, Hirshleifer, and Subrahmanyam (1998)is
closely related, but is derived in a formal model and carries some explicit empirical
predictions. The overconfidence hypothesis is based on the assumption that investors
are overconfident about the precision of their private information, but not about the
precision of public information. Overweighting private information relative to public
information causes underreaction to newpublicinformation. Thus, the theory predicts
that discretionary corporate events (such as equity issues) associated with abnormal
announcement period returns, on average should be followed by long-run abnormal
performance of the same sign as the average announcement period abnormal return, and
there should be a positive correlation between announcement period abnormal returns
and post-offer long-run abnormal returns.
Several empirical papers have explored different aspects of the timing and overconfi-
dence hypotheses.Teoh, Welch, and Wong (1998)look at discretionary accruals in the
years around an equity offering. The idea is that if investors are overly optimistic about
the prospect of firms issuing equity, they would be willing to buy more shares and pay
higher prices for them. As a result, issuing firms have incentives to cultivate this opti-
mism by reporting inflated earnings before an equity offer. Both papers find evidence
of earnings management prior to SEOs. For example,Teoh, Welch, and Wong (1998)
find that although cash flows from operations on average decline prior to the SEOs, the
reported discretionary accruals cause earnings to peak around the offer dates. Moreover,
the amount of discretionary accruals prior to the seasoned equity offering is negatively
related to the post-issue long-run stock return performance. The authors view this as
evidence in favor of timing and overly optimistic investors. However, this issue is not
settled asShivakumar (2000)produces contradictory evidence using the specification
ofTeoh, Welch, and Wong (1998).
Cornett, Mehran, and Tehranian (1998)employ a direct test of the relationship be-
tween the incentive to time an issue and the subsequent stock return performance. They
study voluntary and involuntary SEOs by commercial banks. Capital regulations in the
banking industry state that banks are not allowed to have total capital ratios below a
certain level. If the total capital ratio falls below the regulated lower bound, a bank may
need to issue new equity to raise their capital ratio.Cornett, Mehran, and Tehranian
(1998)define an involuntary SEO as an issue by a bank with capital ratio close to or
below the required minimum ratio. If timing is driving the long-run underperformance
of SEOs, we should expect to see less or no underperformance for involuntary issues.
The results support the timing hypothesis, showing no abnormal three-year post issue
stock return performance for the involuntary issues, while the voluntary issues show
significant underperformance.
Brous, Datar, and Kini (2001)perform another test of the timing and overconfidence
hypotheses. They argue that if managers are timing equity issues and investors system-
atically underreact to the issue announcements, we should expect to see that investors