Question

empirical research consistently documents price drops on the announcement of equity raising. a generally accepted explanation is that managers may choose to sell share when market tend to undervalue the shares. true or false and give reason for answer

Answer 1

the statement is false here

price drop on the announcement of equity raising

i shall explain this with an eaxmple

if the company has 1000 shares of $100 each and income of $5,000 then the earning per share would be 5,000/1000 = $5 each for a price to earning ratio of 20 (100/5)

however if the company raises 100 more shares, everything else keeping the same, the earning per share would be 5000/1100 = $4.54 per share and share price would become 4.54*20 = $90.8 per share

this example illustrates that issuing more shares dilutes the overall earnings of the company and hence value per share falls.

however, share price is based on expectation of the market.

and also according the value investing, the investors tend to buy the shares when the shares are undervalued.

that means intrinsic value of the share > share price

this is same as a product getting at a cheaper price than of it's market price

and as far as selling of shares in the market is concerned, managers usually sell shares as they require capital to grow and to raise funds for furthur expansion.

therefore, issuing more shares is not related to share price being undervalued or overvalued.

these temporary market trading conditions do not influence company to buy or sell shares in the market.