Ch. 6: Security Offerings 333
greater debtholder wealth gains. Thus, there are greater costs to equity issues in eco-
nomic downturns, leading to a lower predicted frequency of equity offers and a more
negative stock price reaction. However, the predicted positive price reaction of outstand-
ing debt to equity offers under the wealth transfer hypothesis is not observed byKalay
and Shimrat (1987).
In theStulz (1990)model of free cash flow, debt issuance becomes more attractive
when a firm’s free cash flow increases. In economic contractions, if earnings decline
less sharply than capital spending, which is typically the case, then free cash flow can
increase, which increases the attractiveness of debt offerings. The cost of debt issuance
in the Stulz model is underinvestment in profitable projects, but this would tend to be
less of a problem in economic downturns. Thus, debt issuance would appear to be pre-
dicted to rise in contractions under the Stulz model, which is contrary to the evidence
inMarsh (1982)andTaggart (1977), but somewhat supported by the evidence reported
byChoe, Masulis, and Nanda (1993). This prediction is also supported by the evidence
found inJung, Kim, and Stulz (1996), who observe that firms with relatively good in-
vestment opportunities measured by the market to book ratio, are significantly more
likely to issue equity over straight debt.
Lucas and McDonald (1990)develop a dynamic model of the equity issuance process
that predicts a greater frequency of equity issuance following a general stock market
increase. They show that since firm’s with temporarily underpriced stock have an in-
centive to postpone an offering until the stock price is higher, the resulting average
pre-announcement price path of these issuing firms will be upward sloping. On the
other hand, firms with temporarily overpriced stock will issue equity immediately as
new investment opportunities arise. If the arrival of investment projects is uncorrelated
with a firm’s price history, then the average pre-equity offering announcement price
path of temporarily overvalued stocks will be flat. As a result, the average preannounce-
ment price path of all issuing firms will be upward sloping, as is typically observed in
samples of firm commitment equity offers. Lucas and McDonald also argue that the
market reaction to an equity issue announcement will be more negative for firms with
higher pre-announcement period stock price gains, which is supported by the regression
results ofMasulis and Korwar (1986), Korajczyk, Lucas, and McDonald (1990), Eckbo
and Masulis (1992), andJung, Kim, and Stulz (1996).
As discussed in Section4, Eckbo and Masulis (1992)point out that increased share-
holder participation in equity issues reduces the incentives of firms with undervalued
equity to postpone their offers since current shareholders capture part of any underpric-
ing. At one extreme, when current shareholders purchase the entire issue (shareholder
takeupk=1), the firm issues immediately regardless of its current degree of underpric-
ing. Thus, in a sample of issuers where the average level of shareholder participation is
known to be large, theEckbo and Masulis (1992)model predicts that there should be lit-
tle or no stock price runup prior to the issue announcement. This prediction is supported
by their evidence of little or no runup prior to an uninsured rights offer announcement, a
modest positive runup prior to standby offer announcement and a larger positive runup
effect prior to a firm commitment underwritten offer announcement.