A Theory of Capital Structure, Price Impact, and LongRun Stock Returns under Heterogeneous Beliefs

1
A Theory of Capital Structure, Price Impact,
and Long-Run Stock Returns under Heterogeneous
Beliefs

• Onur Bayar, University of Texas at San Antonio
• Thomas Chemmanur, Boston College
• Mark Liu, University of Kentucky
• Presented by Thomas Chemmanur
• Rutgers University, October 30, 2009

2
Heterogeneous Beliefs and Corporate Finance

• There has been several analyses of the
  implications of heterogeneous beliefs among
  investors in asset pricing.
• Miller (1977), Harrison and Kreps (1978), Duffie,
  Garleanu, and Pedersen (2002)
• But very little analysis of the implications of
  heterogeneous beliefs among investors for
  corporate finance.
• We address the effect of heterogeneous beliefs on
  the capital structure choice of a firm.
• In our setting, there are heterogeneous beliefs
  among investors, but also between insiders and
  outsiders.
• We study how the heterogeneity in beliefs between
  insiders and outsiders affect the firms choice
  between equity, debt, convertible debt, and
  combinations of debt and equity as well.

3
Heterogeneous Beliefs and the Price Impact of
Security Issues

• While there has been many studies of the
  announcement effect of security issues, there is
  very little analysis of the price impact of
  security issues.
• What is the price impact of a security issue?
• The effect on stock returns on the day the
  security is actually issued (i.e., the abnormal
  return to equity upon a new security issue on the
  date the security is actually issued)
• Does heterogeneity in investor beliefs affect the
  price-impact?
• How does the price impact of an equity issue
  differ from that of a debt or convertible debt
  issue?

4
(No Transcript)
5
Heterogeneous Beliefs and the Long-Term Stock
Returns

• What explains the negative long-run stock returns
  following equity issues?
• Loughran and Ritter (1995)
• What explains the fact that, while the long-term
  stock returns of both equity and debt issuers are
  negative, the long-term stock return of equity
  issuers is significantly more negative than that
  of debt and convertible debt issuers?
• Spiess, Affleck-Graves (1995), Chemmanur, Nandy,
  and Yan (2008)
• Finally, how does the level of outside investor
  optimism about a firm's future prospects and the
  dispersion in outsider's beliefs affect the
  long-term stock returns to issuers of equity,
  debt, and convertible debt?

6
This Paper

• In this paper, our objective is to answer many of
  the above questions theoretically in a
  heterogeneous beliefs framework.
• We analyze a firm's financing decision in an
  environment of heterogeneous beliefs and short
  sales constraints.
• The setting we study is one in which insiders of
  a firm, owning a certain fraction of equity in
  the firm, choose between equity, debt, or
  convertible debt to raise external financing to
  implement a positive net present value project.

7
Related Literature

• Heterogeneous Beliefs and Asset Pricing Miller
  (1977), Harrison and Kreps (1978), Jarrow (1980),
  Mayshaw (1982), Varian (1989), Harris and Raviv
  (1993), Kandell and Pearson (1995), Morris
  (1996), Biais and Bossaerts (1998), Viswanathan
  (2000), Brav and Heaton (2002), Duffie, Garleanu,
  and Pedersen (2002), Chen, Hong, and Stein
  (2002), Diether, Malloy, and Scherbina (2002),
  Kyle and Lin (2003), Cao and Ou-yang (2004),
  Scheinkman and Xiong (2004), Nagel (2005)
• Heterogenous Beliefs and Economic Theory Aumann
  (1976), Kreps (1990), Kurz (1994), Morris (1995)
• Disagreement among Agents and External Financing
  Allen and Gale (1999), Garmaise (2001), Dittmar
  and Thakor (2007)
• The broader literature on capital structure
  driven by considerations other than heterogeneity
  in beliefs see, e.g., Harris and Raviv (1991)

8
Summary of Empirical Implications

• The greater the level of optimism (average
  belief) among outsiders, and the greater the
  dispersion in outsider beliefs (or both), the
  more likely the firm is to choose to issue equity
  rather than debt.
• The belief of the marginal investor in the firm's
  equity is more likely to be above that of firm
  insiders if either the level of optimism, or
  dispersion of beliefs, or both, among outsiders
  is higher.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).
• The greater the investment amount to be raised by
  the firm, the less likely it is to issue equity
  rather than debt.
• Since each investor has limited wealth to invest
  in the firm, the beliefs of the marginal investor
  is more likely to fall below that of insiders as
  the amount raised by the firm is greater.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

9
Summary of Empirical Implications

• The price impact of an equity issue will be
  negative. Further, the fall in share price upon
  an equity issue will be greater as the dispersion
  in outsider beliefs is greater i.e., the greater
  the dispersion in outsiders beliefs, the more
  negative the price impact of an equity issue.
• Since current shareholders have limited wealth,
  when new equity is issued it will have to be sold
  to new investors who are less optimistic about
  the firm's long-term prospects, so that the
  beliefs of the marginal investor after the equity
  issue will be less optimistic compared to that
  before the equity issue, resulting in a lower
  share price after the equity issue.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).
• The price impact of a debt or convertible debt
  issue will be zero.
• Since no new equity is issued, the beliefs of the
  marginal equity investor before the firm's debt
  (convertible debt) issue and the marginal
  investor holding the firm's equity after the debt
  (convertible debt) issue will be the same in
  these cases.

10
Summary of Empirical Implications

• The long-run stock returns to a firm issuing
  equity will always be negative. The long-run
  post-issue stock return will be more negative as
  the optimism and dispersion in outsider beliefs
  is greater.
• In equilibrium, a firm will issue equity only if
  the beliefs of the marginal holder of the firm's
  equity after the equity issue, are more
  optimistic than that of firm insiders.
• Consequently, since the actual realization of the
  firm's long-run cash flow is close to insider
  beliefs on average, the long-run stock returns
  following an equity issue will be negative.
• Since the beliefs of the marginal investor in the
  firm's equity will be increasing in the optimism
  of outsider beliefs and in the dispersion of
  these beliefs, the long-term fall in the firm's
  share price will be greater if the level of
  optimism and dispersion in outsider beliefs is
  greater.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

11
Summary of Empirical Implications

• The long-run stock return upon a debt issue will
  be algebraically greater (less negative, or more
  positive) than the corresponding long-run stock
  returns upon an equity issue.
• The firm will issue debt only when outside
  investors in the firm's equity are relatively
  more pessimistic about the firm's long-term
  prospects. In other words, in a situation where a
  firm issues debt, the marginal equity investor
  beliefs are likely to be less optimistic than the
  marginal equity investor beliefs upon an equity
  issue.
• Since the long-run (time-2) stock price of all
  firms will reflect only the realized value of the
  firm's cash flows (which, in turn, coincide with
  insider beliefs, on average), the above implies
  that the long-run stock return of equity issue
  will be lower than that of the straight debt
  issue.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

12
Summary of Empirical Implications

• The long-run stock returns of a firm following a
  convertible debt issue will be algebraically
  greater than that following an equity issue but
  will be smaller than that following a debt issue.
  
• The beliefs of the marginal equity investor in
  the firm following a convertible debt issue are
  likely to be more optimistic than marginal equity
  investors beliefs following a debt issue but
  less optimistic than that following an equity
  issue.

13
Sequence of Events
Time 0
Time 1
Time 2
At time 0, insiders of a firm own a fraction ? of
the firm's equity. The remaining 1- ? is held by
a group of outside shareholders. The total
number of shares outstanding in the firm is
normalized to 1.
The required amount of investment I for the
project is raised from outside investors by
issuing either equity, or straight debt, or
convertible debt, or a combination of these
securities.
All cash flows are realized.
14
Setup of the Model

• At time 0, insiders of a firm own a fraction ? of
  the firm's equity. The remaining (1- ?) is held
  by a group of outside shareholders.
• The firm needs to raise external financing of I
  from outside investors to fund a new project at
  time 1.
• The cash flows of the project will be realized at
  time 2.
• They can be either XH or XL, where XL lt I lt XH.
• There is a continuum of outside investors in the
  capital market, with an aggregate wealth amount
  of W.
• Each investor has the same limited amount of
  wealth.
• Current outside shareholders holding the
  outstanding stock in the firm have already
  exhausted their wealth so that they cannot buy
  any further securities issued by the firm at time
  1.
• The capital market is characterized by
  heterogeneity in beliefs about the future cash
  flows of the firm, both between insiders and
  outsiders, and across outside investors.

15
Setup of the Model

• Market participants, each of whom have limited
  wealth to invest in the firm, have heterogeneous
  beliefs about the long-term value (future cash
  flows at time 2) of the firm, which differs from
  that of the insiders.
• Firm insiders believe that with probability ? f,
  the cash flow will be XH, and with probability
  (1- ? f), the cash flow will be XL.
• We assume that so that firm insiders believe that
  the project has positive NPV, i.e., ? f XH (1- ?
  f ) XL gt I.
• Outside investors' beliefs about the value of the
  firm are uniformly distributed over the interval
  ? m- d, ? m d . We can think ? m as the
  average or mean belief of outsiders, and d as
  the dispersion (heterogeneity) in outsiders'
  beliefs.
• We also refer to ? m as the level of optimism
  among potential outside investors.

16
Beliefs of insiders and outsiders about the cash
flow of the firm
XH
?
? f
Outsider beliefs, ? ? ?m d, ?m d
Insider belief, ? f
1-? f
1-?
XL
17
Setup of the Model

• The menu of securities available to the firm
  consists of common equity, straight debt, and
  convertible debt.
• In our basic model, the firm does not incur any
  frictional cost of issuing securities (i.e., no
  issue or underwriting costs) or costs of
  financial distress even if it is in default on
  its promised payment on debt issued (either
  straight debt or convertible debt).
• We introduce both the above costs in our
  full-fledged model.
• All investors are subject to a short-sale
  constraint i.e., no short selling in the firm's
  security is allowed in the economy.
• There is a risk-free asset in the economy, the
  net return on which is normalized to 0. All
  agents are risk-neutral.

18
Setup of the Model

• The objective of firm insiders is to make their
  choice of security (or combination of securities)
  to issue such that they maximize the long-term
  wealth of the current shareholders, based on
  insiders belief ? f.
• Objective function of firm insiders MaxS
  E1CFequity, 2 S, ? f
• E1CFequity, 2 S, ? f is the time-1 expected
  value (according to firm insiders' belief) of the
  time-2 cash flows to the current equity holders
  of the firm, conditional on issuing security S.
• The security choice S can be either equity, or
  straight debt, or convertible debt, or a
  combination of these securities.

19
Basic ModelEntire Financing is raised by issuing
only one security

• If the firm can issue only one type of security
  in order to raise the required amount of I for
  the project from outside investors, then
• The firm will choose to issue equity alone if
  outsiders are more optimistic about the firm on
  average and their beliefs are more dispersed so
  that the marginal outside investor is more
  optimistic than firm insiders.
• The firm will choose to issue straight debt alone
  if outsiders are more pessimistic about the firm
  on average and their beliefs are less dispersed
  so that the marginal outside investor is less
  optimistic than firm insiders.
• The firm will never choose to issue convertible
  debt in the absence of issue costs or costs of
  financial distress, since convertible debt will
  be dominated by either equity alone or straight
  debt alone, depending on outsiders' beliefs.

20
Basic ModelEntire Financing is raised by issuing
only one security

• When the marginal outside investor is are more
  optimistic about the firm's future cash flows
  than firm insiders, all three securities (equity,
  straight debt, or convertible debt) will be
  overvalued relative to firm insiders' belief.
• However, since equity is the security which is
  most sensitive to outsider beliefs, it will also
  be the most overvalued security based on
  insiders' beliefs if the marginal outside
  investor is more optimistic than firm insiders.
• If we rank each security based on its value
  sensitivity to outsiders' beliefs about the
  firm's future cash flows, equity is the most
  sensitive security since its payoffs are
  perfectly positively correlated with the state of
  the firms cash flow.
• Straight debt is the least sensitive security to
  investor beliefs since it promises the repayment
  of a fixed face value F unless the firm defaults
  in the future.
• Convertible debt which is a hybrid of straight
  debt and equity ranks in between with respect to
  its price sensitivity to outsider beliefs.
• Therefore, in this scenario, we show that the
  firm chooses to issue equity alone instead of the
  other two securities in order to best capture
  outside investors' optimism.

21
Beliefs of insiders and outsiders in the scenario
where the firm chooses to issue equity alone
instead of debt alone
22
Basic ModelEntire Financing is raised by issuing
only one security

• On the other hand, when outside investors are
  more pessimistic about the firm's future cash
  flows on average, and their beliefs are less
  dispersed, the marginal investor's belief will be
  below that of firm insiders.
• If the firm chooses to sell equity in this case,
  its equity will be substantially undervalued
  relative to the insiders' belief.
• Therefore, the firm will choose to issue straight
  debt since this security is less sensitive to
  outsider beliefs than either equity or
  convertible debt, and therefore the least
  undervalued.

23
Beliefs of insiders and outsiders in the scenario
where the firm chooses to issue debt alone
instead of equity alone
24
Basic Model The case where the firm issues
equity alone

• The firm will offer equity only to the most
  optimistic investors in the market.
• How much these investors are willing to pay for
  the firm's equity depends on two factors
• The first factor is the average belief ? m of
  investors in the market
• The higher this average belief, the higher the
  beliefs of the group of outside investors who buy
  equity in the firm.
• The other factor is the dispersion d in outside
  investors' beliefs
• Holding the average belief constant, a higher
  dispersion in outside investors' beliefs means
  that more outside investors will be very
  optimistic about the future prospects of the firm
  so that the firm can sell its equity at a higher
  price to its new investors.
• The price at which the firm sells shares to
  outsiders depends on the belief of the marginal
  outside investor in the firm's equity, denoted by
  .

25
Basic Model The case where the firm issues
equity alone

• The marginal investor is determined by starting
  with the most optimistic outside investor willing
  to invest in the firm (whose belief is given by
  (? m d ) and working down the ladder of outside
  investors' beliefs until the entire amount I
  required for investment in the firm is raised by
  selling equity.

26
Basic Model The case where the firm issues
equity alone

• The higher the amount of money I the firm needs
  to raise from outsiders, the lower down the
  ladder the firm needs to go in terms of
  outsiders' beliefs.
• Therefore the less optimistic the marginal
  investor holding the firm's equity subsequent to
  the equity issue will be.
• Hence, the less optimistic the marginal investor
  holding the firm's equity, the lower the price of
  the firm's equity will be.

27
Basic Model The case where the firm issues debt
alone

• When the firm issues straight debt alone in order
  to raise the required amount of new financing I,
  it raises these funds from the same group of
  investors as in the above case where it issues
  equity alone.
• In other words, similar to an equity issue, the
  firm starts with the outside investor who is most
  optimistic about the firm's future cash flows and
  works down the ladder of outsiders' beliefs until
  the entire amount I is raised by selling straight
  debt.
• The marginal investor in the firm's debt is the
  same as the marginal investor in its equity if
  the firm were to issue equity only.
• The price at which each unit of straight debt is
  sold, denoted by PD1 is the price at which the
  marginal investor breaks even, given his belief
  . The firm issues F units of straight debt such
  that it is able to raise the entire investment
  amount I.

28
Basic Model The case where the firm issues
convertible debt alone

• When the firm issues convertible debt alone in
  order to raise the required amount of new
  financing I, it raises these funds from the same
  group of investors as in the earlier cases where
  it issues equity alone or straight debt alone.
• Thus, the marginal investor in the firm's
  convertible debt is determined by starting with
  the outside investor who is most optimistic about
  the firm's future cash flows and working down the
  ladder of outsider beliefs until the entire
  amount I required for investment in the firm is
  raised by selling convertible debt.
• Therefore, the belief of the marginal outside
  investor in the firm's convertible debt is
  identical to the belief of the marginal investor
  in the above cases where the firm issues equity
  or straight debt alone.

29
Basic Model The case where the firm issues
convertible debt alone

• The difference in beliefs between firm insiders
  and outside investors plays a critical role in
  the pricing and the design of the convertible
  debt security.
• When outsiders are sufficiently more optimistic
  about the firm's future cash flows on average
  (i.e., the outsiders' average belief ? m is high)
  and their beliefs are sufficiently heterogeneous
  (i.e., the dispersion d in outsiders' beliefs is
  high), the marginal outside investor will also be
  more optimistic about the firm's future cash
  flows than firm insiders (i.e., ).
• In this case, it is optimal for firm insiders to
  maximize the equity component of the convertible
  debt by setting the conversion ratio x as high as
  possible.
• Since the equity component of convertible debt
  will be overvalued by the marginal outside
  investor relative to firm insiders' belief, firm
  insiders will seek to benefit from capturing the
  outsiders' optimism on behalf of the existing
  shareholders by maximizing the equity component
  of convertible debt.

30
Basic Model The case where the firm issues
convertible debt alone

• When the marginal outside investor is less
  optimistic about the firm's future cash flows
  than firm insiders (i.e., ), it is
  optimal for firm insiders to minimize the equity
  component of the convertible debt since this
  component will now be undervalued relative to
  firm insiders' belief.

30
31
Basic ModelFinancing Raised by Issuing a
Combination of Securities The Case where Equity
alone is optimal

• The firm will choose to issue equity alone when
  outsiders are sufficiently optimistic about the
  firm on average, and their beliefs are
  sufficiently dispersed.
• When the average outside investor is very
  optimistic about the firm's future cash flows and
  outsiders' beliefs are very dispersed, the
  marginal outside investor will be willing to pay
  a very high price for the firm's equity based on
  the insiders belief.
• It will be optimal for the firm to issue equity
  alone in order to capture the high degree of
  optimism of the marginal outside investor.

32
Basic Model Financing Raised by Issuing a
Combination of Securities The Case where a
Combination of Debt and Equity is optimal

• When outsiders are pessimistic about the firm on
  average, and their beliefs are not sufficiently
  dispersed, the firm will choose to issue a
  combination of straight debt and equity.
• Starting with the most optimistic outside
  investor with belief (? m d ) and going down
  the ladder of outsider beliefs, the firm can
  raise some money (I-ID) by issuing equity to the
  most optimistic investors and the rest (ID) by
  issuing debt to the less optimistic investors
  until the entire amount of I is raised.
• In this way, as long as the most optimistic
  outside investor is more optimistic than the firm
  insiders, i.e., (? f lt ? m d ) the firm can
  still capture and benefit from the optimism of
  the mass of most optimistic outsiders by issuing
  some equity to them.
• On the other hand, by issuing some debt
  simultaneously, the firm will minimize the
  undervaluation effect caused by the views of less
  optimistic and downright pessimistic outside
  investors.

33
Basic Model Financing Raised by Issuing a
Combination of Securities The Case where a
Combination of Debt and Equity is optimal

• If it is feasible for the firm to issue a
  combination of debt and equity, issuing debt
  alone is never optimal since this fails to
  capture the optimism of those investors with very
  optimistic beliefs about the firm.
• If there exist some very optimistic outside
  investors who value the firm higher than the
  insiders, the firm can benefit from the optimism
  of these outsiders by issuing some equity to
  them.
• Issuing a combination of equity and debt
  dominates issuing debt alone as long as there
  exists some heterogeneity in outsiders' beliefs.

34
Basic ModelFinancing Raised by Issuing a
Combination of Securities Is Convertible Debt
optimal?

• In the absence of issuance costs and costs of
  financial distress, convertible debt is always
  dominated by either a combination of straight
  debt and equity, or equity alone.
• If the marginal outside investor is more
  optimistic than firm insiders, equity alone
  dominates convertible debt, since equity alone is
  the most belief-sensitive security that best
  captures outsiders optimism.
• If the marginal outside investor is less
  optimistic than firm insiders, a combination of
  straight debt and equity dominates convertible
  debt.
• When the firm issues convertible debt, the equity
  component and the debt component of the security
  have to be sold to the same group of investors.
• But the firm can do better than that by issuing
  some equity to the most optimistic set of outside
  investors, and by issuing some debt to the
  remaining less optimistic outside investors.
• When the firm issues convertible debt, it is
  unable to achieve the optimal price
  differentiation between its debt and equity
  components.

35
Extended Model Entire Financing is raised by
issuing only one security

• We introduce two costs into our full-fledged
  model issue costs and costs of financial
  distress.
• If the firm can issue only one type of security
  in order to raise the required amount of I for
  the project from outside investors, then
• The firm will choose to issue equity alone if the
  marginal outside investor is more optimistic than
  firm insiders.
• The firm will choose to issue convertible equity
  alone if the marginal outside investor is
  moderately less optimistic than firm insiders.
• The firm will choose to issue straight debt alone
  if the marginal outside investor is much less
  optimistic than firm insiders.

36
Extended Model Entire Financing is raised by
issuing only one security

• When the marginal outside investor is less
  optimistic than firm insiders, equity is no
  longer the optimal security to issue.
• In this case, the choice between straight debt
  and convertible debt depends on the following
  trade-off.
• On the one hand, the convertible debt has an
  equity component embedded in it, which will be
  undervalued relative to insider belief in this
  situation (unlike straight debt, whose valuation
  is relatively insensitive to outsider beliefs)
  the undervaluation effect.
• On the other hand, the option to convert to
  equity embedded in the convertible debt is
  valuable to outsiders so that it reduces the face
  value of the debt to be offered to them (in
  return for a given amount of financing), thereby
  reducing the probability of the firm going into
  financial distress and therefore, the expected
  financial distress cost incurred by the firm the
  embedded option effect.

37
Extended Model Entire Financing is raised by
issuing only one security

• When the marginal outside investor is much more
  pessimistic than firm insiders, the
  undervaluation effect will be very large while
  the embedded option effect will be relatively
  small
• The undervaluation effect will dominate the
  embedded option effect, and the firm will issue
  straight debt rather than convertible debt.
• Conversely, when the marginal outside investor is
  only slightly less optimistic than firm insiders,
  then the embedded option effect dominates the
  undervaluation effect, and the firm finds it
  advantageous to issue convertible debt rather
  than straight debt.

38
Extended Model Entire Financing is raised by
issuing only one securityPecking Order of
External Financing

• The belief of the marginal investor relative to
  that of firm insiders determines a pecking
  order of external financing under heterogeneous
  beliefs.
• Thus, when the average outsider is very
  optimistic, and outsiders beliefs are very
  dispersed, so that the marginal outside investor
  is more optimistic than firm insiders, the firm
  always chooses to issue equity alone to raise
  external financing.
• When the average outside investor is less
  optimistic, and outsiders beliefs are moderately
  dispersed, so that the marginal investor is
  slightly less optimistic than firm insiders, the
  firm chooses to issue convertible debt to raise
  external financing.
• Finally, when the average outsider investor is
  quite pessimistic, and outsiders beliefs are not
  dispersed, so that the marginal investor is
  significantly more pessimistic than firm
  insiders, then the firm issues straight debt.

39
Extended Model Financing Raised by Issuing a
Combination of Securities

• The firm will choose to issue equity alone, when
  outside investors are more optimistic about the
  firm's future cash flows on average, and the
  outsiders' beliefs are highly dispersed.
• When outside investors are less optimistic about
  the firm's future cash flows on average, and the
  heterogeneity in outsiders' beliefs is low, then
• It is optimal for the firm to issue debt alone if
  the issuing cost is high
• It is optimal for the firm to issue a combination
  of debt and equity if the issuing cost is low

40
Extended Model Financing Raised by Issuing a
Combination of Securities

• If the marginal equity investor is much more
  optimistic about the firms future cash flow than
  insiders, the firm will issue equity only in
  order to fully capture the wide-ranging optimism
  of outside investors.
• Conversely, when the average outside investor is
  less optimistic and the outsiders beliefs are
  less dispersed, the marginal outside investor
  will value the firm lower than firm insiders.
• Then, the firm will choose between straight debt
  alone and a combination of equity and debt based
  on the following trade-off
• On the one hand, issuing a combination of debt
  and equity allows the firm to raise some money by
  selling equity to most optimistic investors and
  the rest by selling debt to less optimistic
  investors.

41
Extended Model Financing Raised by Issuing a
Combination of Securities

• The firm can capture the optimism of the mass of
  very optimistic investors in the market by
  selling equity to them at a relatively high
  price. By issuing some debt simultaneously, the
  firm will reduce the negative valuation impact of
  the opinions of less outside investors.
• On the other hand, issuing a combination of debt
  and equity also means that the firm has to pay
  issuing costs on two tranches of securities
  instead of just one.
• Therefore, the firm incurs more issuing costs
  when it issues a combination of debt and equity.
• The firm will choose to issue straight debt alone
  when the issue costs are very high and it will
  choose to issue a combination of debt and equity
  when the issue costs are relatively low compared
  to the price differentiation benefits of the
  debt-equity combination.

42
Extended Model Financing Raised by Issuing a
Combination of SecuritiesWhen is convertible
debt optimal?

• It is optimal for the firm to issue convertible
  debt when the dispersion d in outsiders' beliefs
  is low and the issuing cost CI is high.
• It is optimal for the firm to issue a combination
  of straight debt and equity when the dispersion
  in outsiders' beliefs d is high and the issuing
  cost CI is low.
• Issuing a combination of straight debt and equity
  means that the firm can sell its securities at
  higher prices because the firm can sell equity to
  the most optimistic outside investors at a
  relatively high price and sell debt to the less
  optimistic outsiders.
• The benefits of issuing a combination of debt and
  equity over issuing convertible debt increases
  with the dispersion d in outsider beliefs because
  more dispersed outsider beliefs imply the
  existence of a greater mass of very optimistic
  outside investors to whom the firm can sell
  equity at a relatively high price compared to the
  insiders' beliefs.

43
Extended ModelFinancing Raised by Issuing a
Combination of SecuritiesWhen is convertible
debt optimal?

• In contrast, when the firm issues convertible
  debt, the equity component and the debt component
  of the security have to be sold to the same group
  of investors, and therefore the firm is unable to
  capture the optimism among the most optimistic
  outside investors.
• Issuing convertible debt rather than a
  combination of debt and equity can save the firm
  issuing costs. The issue cost saving benefit of
  the convertible debt increases with the issue
  cost CI.
• When the dispersion d in outsiders' beliefs is
  low and the issuing cost CI is high, the cost
  saving benefit of convertible debt outweighs the
  valuation benefit of the debt-equity combination,
  and it is optimal for the firm to issue
  convertible debt.

44
Extended Model The Price Impact of Security
Issues

• Price Impact the abnormal return of the firms
  stock measured on the day a security issue
  actually comes into effect (not on the
  announcement date).
• Our model shows that, if the firm issues equity
  at time 0, there is a negative impact on the
  stock price
• If the firm issues straight debt or convertible
  debt, there is no impact on the stock price

45
Extended Model The Price Impact of Security
Issues

• Further, the greater the dispersion in outsiders
  beliefs, d, the greater the price impact of an
  equity issue
• When the firm issues equity, it must sell the
  equity to investors who are less optimistic about
  the firm's value than current shareholders (since
  the current shareholders have limited wealth),
  and the equity valuation of the new marginal
  equity holder will be lower than that before the
  equity issuance.
• Therefore, the stock price decreases, yielding a
  negative price impact.
• On the other hand, if straight debt or
  convertible debt is issued, the marginal investor
  who holds equity in the firm remains the same.
• The valuation of the marginal equity holder is
  unaffected, resulting in a zero price impact of
  the straight debt issue or convertible debt issue
  on the firm's equity.

46
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• We analyze the long-run stock returns of firms
  following equity, straight debt, and convertible
  debt issues that have been studied extensively in
  the empirical literature.
• Additional assumption In the long run (i.e., at
  time 2), the time-0 beliefs of firm insiders
  about the firm's prospects turn out to be correct
  on average (i.e., they coincide with the actual
  realization of the firms time-2 cash flows on
  average).

47
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• The long-run stock return of firms following
  equity issues will always be negative
• We showed that firms will find it optimal to
  issue equity only when outsiders are relatively
  more optimistic compared to firm insiders, so
  that the belief of the marginal investor buying
  the firm's equity will be above that of firm
  insiders.
• Given that the long-run (time-2) stock price of
  the firm will reflect the beliefs of firm
  insiders, the long-run stock returns of firms
  subsequent to equity issues will always be
  negative.

48
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• The long-run stock returns of equity issuers will
  be more negative as the average outside investor
  is more optimistic, and the heterogeneity in
  outsiders' beliefs is greater
• The more optimistic the marginal outside equity
  investor is, the greater will be his (time-1)
  equity valuation than that of the insiders.
• The incremental optimism of the marginal investor
  is increasing in both the average level optimism
  (? m) of outsiders and the dispersion (d) in
  their beliefs.
• Given that the long-run (time-2) stock price of
  the firm will reflect the beliefs of firm
  insiders, the long-run stock returns of firms
  subsequent to equity issues will be more negative
  if the marginal investor at the time of equity
  issuance (time 1) is more optimistic.

49
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• Long-run stock returns following straight debt
  and convertible debt issues
• If ? f gt ? m d, the long-run stock return is
  positive when the firm issues straight debt or
  convertible debt at time 1
• If ? f ? m d, the long-run stock return is
  zero when the firm issues straight debt or
  convertible debt at time 1
• If ? f lt ? m d, the long-run stock return is
  negative when the firm issues straight debt or
  convertible debt at time 1.
• Unlike in the case of an equity issue, issuing
  straight debt or convertible debt does not affect
  the marginal investor in the firm's equity.

50
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• Therefore, the stock price of the firm
  immediately after a debt (either straight or
  convertible) issue will reflect only the beliefs
  of the current marginal investor in the firm's
  equity (i.e., ? m d).
• If the long-run (time-2) stock prices of firms
  reflect the beliefs of firm insiders (? f ) at
  the time of the debt issue (on average), then
• If current shareholders are optimistic relative
  to firm insiders, the long-run stock return
  following a debt issue will be negative.
• On the other hand, if current shareholders in the
  firm are pessimistic relative to firm insiders,
  the long-run stock returns following a debt issue
  will be positive.
• Finally, when current shareholders have similar
  beliefs about the firm's prospects compared to
  firm insiders, the long-run stock return
  following a debt issue will be zero.

51
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• Comparison of long-run stock returns across
  security issues The average long-run stock
  return following a straight debt issue will be
  greater than that following a convertible debt
  issue, which in turn, will be greater than that
  following an equity issue.
• A firm issues equity only when the beliefs of
  outsiders are sufficiently optimistic so that the
  belief of the marginal investor in the firm's
  equity is above that of firm insiders.
• On the other hand, a firm issues straight debt or
  convertible debt only the when outsiders are
  relatively pessimistic, so that the belief of the
  marginal investor (if the firm were to issue
  equity) would be below that of firm insiders.
• Therefore, the belief of the marginal investor
  holding the equity of a firm issuing stock will
  be more optimistic than that of the marginal
  equity investor in a firm issuing straight debt
  or convertible debt.

52
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• Since the long-run (time-2) stock price of all
  firms will reflect only the realized value of the
  firm's cash flows (which, in turn, coincide with
  insider beliefs, on average), the above implies
  that the long-run stock return of equity issue
  will be lower than that of issues of straight
  debt or convertible debt.

53
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• A firm will issue straight debt when outsiders
  are so pessimistic that the belief of the
  marginal investor in the firm's equity will be
  significantly below that of firm insiders (if it
  were to undertake on equity issue).
• Firm insiders will issue convertible debt if the
  outsiders beliefs are only moderately
  pessimistic so that the belief of the marginal
  investor in the firm's equity (if it were to
  undertake on equity issue), while below that of
  insiders' belief, will be closer to them.
• This implies that the belief of the marginal
  investor currently holding the equity of a firm
  making a straight debt issue will be above that
  of the marginal investor currently holding the
  equity of a firm making a convertible issue
• In other words, the stock price immediately after
  the issue of a firm making a convertible debt
  issue will be higher than that of a firm making a
  straight debt issue.

54
Extended Model with an additional
assumptionLong-Run Stock Returns Following
Security Issues

• Since the long-run (time-2) stock price of all
  firms will reflect only the realized value of the
  firm's cash flows (which, in turn, coincide with
  insider beliefs, on average), the above implies
  that the long-run stock return of a convertible
  debt issue will be lower than that of the
  straight debt issue.

55
Empirical Implications

• The greater the level of optimism (average
  belief) among outsiders, and the greater the
  dispersion in outsider beliefs (or both), the
  more likely the firm is to choose to issue equity
  rather than debt.
• The belief of the marginal investor in the firm's
  equity is more likely to be above that of firm
  insiders if either the level of optimism, or
  dispersion of beliefs, or both, among outsiders
  is higher.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).
• The greater the investment amount to be raised by
  the firm, the less likely it is to issue equity
  rather than debt.
• Since each investor has limited wealth to invest
  in the firm, the beliefs of the marginal investor
  is more likely to fall below that of insiders as
  the amount raised by the firm is greater.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

56
Empirical Implications

• The price impact of an equity issue will be
  negative. Further, the fall in share price upon
  an equity issue will be greater as the dispersion
  in outsider beliefs is greater i.e., the greater
  the dispersion in outsiders beliefs, the more
  negative the price impact of an equity issue.
• Since current shareholders have limited wealth,
  when new equity is issued it will have to be sold
  to new investors who are less optimistic about
  the firm's long-term prospects, so that the
  beliefs of the marginal investor after the equity
  issue will be less optimistic compared to that
  before the equity issue, resulting in a lower
  share price after the equity issue.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).
• The price impact of a debt or convertible debt
  issue will be zero.
• Since no new equity is issued, the beliefs of the
  marginal equity investor before the firm's debt
  (convertible debt) issue and the marginal
  investor holding the firm's equity after the debt
  (convertible debt) issue will be the same in
  these cases.

57
Empirical Implications

• The long-run stock returns to a firm issuing
  equity will always be negative. The long-run
  post-issue stock return will be more negative as
  the optimism and dispersion in outsider beliefs
  is greater.
• In equilibrium, a firm will issue equity only if
  the beliefs of the marginal holder of the firm's
  equity after the equity issue, are more
  optimistic than that of firm insiders.
• Consequently, since the actual realization of the
  firm's long-run cash flow is close to insider
  beliefs on average, the long-run stock returns
  following an equity issue will be negative.
• Since the beliefs of the marginal investor in the
  firm's equity will be increasing in the optimism
  of outsider beliefs and in the dispersion of
  these beliefs, the long-term fall in the firm's
  share price will be greater if the level of
  optimism and dispersion in outsider beliefs is
  greater.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

58
Empirical Implications

• The long-run stock return upon a debt issue will
  be greater (less negative, or more positive) than
  the corresponding long-run stock returns upon an
  equity issue.
• The firm will issue debt only when outside
  investors in the firm's equity are relatively
  more pessimistic about the firm's long-term
  prospects. In other words, in a situation where a
  firm issues debt, the marginal equity investor
  beliefs are likely to be less optimistic than the
  marginal equity investor beliefs upon an equity
  issue.
• Since the long-run (time-2) stock price of all
  firms will reflect only the realized value of the
  firm's cash flows (which, in turn, coincide with
  insider beliefs, on average), the above implies
  that the long-run stock return of equity issue
  will be lower than that of the straight debt
  issue.
• Evidence supporting this prediction is provided
  by Chemmanur, Nandy, and Yan (2008).

59
Empirical Implications

• The long-run stock returns of a firm following a
  convertible debt issue will be algebraically
  greater than that following an equity issue but
  will be smaller than that following a debt issue.
  
• The beliefs of the marginal equity investor in
  the firm following a convertible debt issue are
  likely to be more optimistic than marginal equity
  investors beliefs following a debt issue but
  less optimistic than that following an equity
  issue.

60
Conclusion

• We have analyzed a firm's choice between equity,
  debt, convertible debt, and combination of equity
  and debt under heterogeneous beliefs and short
  sales constraints.
• When the belief of the marginal outside investor
  is more optimistic than that of firm insiders,
  the firm issues equity alone.
• When the belief of the marginal outside investor
  is less optimistic than that of firm insiders,
  the firm issues a combination of equity and debt,
  convertible debt, or straight debt alone
  depending on the magnitudes of issuance costs and
  financial distress costs.
• We show that the price impact of an equity issue
  on the firms stock price will be negative, while
  the price impact of a straight debt or
  convertible debt issue on the firms stock price
  will be negligible.

61
Conclusion

• We developed a rationale for negative long-term
  stock returns following equity issues, and we
  demonstrated that the long-term stock returns
  following debt and convertible debt issues will
  be algebraically larger than those following
  equity issues.

62
(No Transcript)
63
(No Transcript)
64
(No Transcript)