Raising Capital Theory and Evidence

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Introduction
New information announcements about security offerings by publicly listed firms can cause one of three reactions in the financial markets: (i) positive, (ii) negative, or (iii) indifferent reactions. These responses are measured in the average two-day common stock price reactions adjusted for general market price changes (abnormal returns) to announcements of public issues of common stock, preferred stock, convertible preferred stock, straight debt and convertible debt. Stock markets react to such news by adjusting the market value of the company either upwards or downwards. to take account of the newly announced information.

In 1986, Clifford W. Smith Jr., took note of some very important patterns about the stock market’s reactions security offerings and explored them through his article entitled Raising Capital: Theory and Evidence. His primary finding was that, on average, announcements either lead to reductions in the market valuations of companies issuing securities or being ‘insignificantly different from zero.’ Furthermore he noted that there is usually no significant positive reaction to the valuation of a company as a result of a new security offer announcement.

His findings also differentiated and drew correlations among the types of security offerings and the intensity of market response. The stock market’s reaction to common stock offers was ‘more strongly negative’ than when preference stock and debt capital was issued. As a senior claim to common stock, it could be argued that issuing debt capital communicates information about management’s confidence in the firm to the financial markets. Smith also observed that stock markets react more unfavorably to announcements of issue of convertible loans when compared to issuance of non convertible loans. Given the characteristics of convertible loans, which contain elements of common stock, these negative reactions seemed to fit the general pattern of findings.

Once a firm has decided on the type of security to issue it must then take into account the different methods of marketing it. These options include pro-rata issuance to existing stockholders, hiring underwriters to issue securities publicly, or private placement of securities.

Against this backdrop, Clifford W. Smith laid out two primary objectives to be addressed in the article: (i) to examine evidence on market response to security offerings by public expectations, and (ii) to evaluate methods of marketing corporate securities. This report draws upon and provides critiques of Smith’s survey of three less credible explanations, (Optimal Capital Structure, Earning Per Share Dilution, and Price Pressures) and three more important explanations for the market reactions to security offerings: (i) Unanticipated Announcements; (ii) Insider Information; and (iii) Ownership Changes. Additionally, the report tracks the evolution of the decision-making process from choice of security, through Smith’s three identified tradeoffs in marketing corporate securities: (i) rights versus underwritten offerings; (ii) negotiated versus competitive bid contracts; and (iii) traditional versus shelf registration. The special case of initial public offerings (IPO) is also evaluated. Finally, the report provides an overall evaluation of Smith’s body of work in relation to present day finance.

Survey of Potential Explanations for Market Responses

Optimal Capital Structure (OCS)
As explained in chapters 15 and 16 of the Financial Management textbook, firms organize their capital to maximize the wealth of the firm, and achieve the lowest weighted average cost of capital. Therefore, in this context the OCS argument puts forth an idea purported by some financial economists that negative market response could be related to investors fear of a new issuance moving a firm’s capital structure away from its optimum. However, this does not align well with evidence that shows a consistently negative response,...
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