Question

Below is the market reaction in term of the change of stock price to different

activities adopted by firms. For example, the stock price decreases on average 3% when a

firm announces a seasoned equity offering; the stock price increases on average 5% when

a firm announces stock repurchase.

Issuing seasoned equity -3% reaction on average

Issuing public bonds 0% reaction on average

Issuing bank loans +2% reaction on average

Announcing stock repurchase +5% reaction on average

Can you provide rational explanation on these phenomena using corporate finance theories

Answer 1

Issuing seasoned equity -3% reaction on average : When companies issue additional shares, it increases the number of common stock being traded in the stock market. For existing investors, too many shares being issued can lead to share dilution. Share dilution occurs because the additional shares reduce the value of the existing shares for investors.

For example, let's say a company has 100 shares outstanding, and an investor owns ten shares or 10% of the company's stock. If the company issues 100 additional new shares, the investor now has 5% ownership of the company's stock since the investor owns five shares out of 200. In other words, the investor's holdings have been diluted by the newly issued shares.

Issuing public bonds 0% reaction on average : Bondholders differ from stockholders because they do not have any ownership stake in the company. Instead, bondholders essentially lend a corporation money under a set of rules/ objectives (covenants) the company needs to follow to maintain good standing with the bondholder. Once the bond matures, bondholders receive the principal investment back from the company. Thus, they donot affect shareholder’s wealth in any sense.

Issuing bank loans +2% reaction on average : For a company, debt is an effective tool to raise funds for expansion and development without diluting ownership control. Over exposure to equity for financing capex could lead to a fall in earnings per share (EPS). Debt, on the other hand, helps a firm enjoy the benefits of financial leverage, which can also help improve the return on equity (ROE) for shareholders.

Announcing stock repurchase +5% reaction on average: Since a share repurchase reduces a company’s outstanding shares, its biggest impact is evident in per-share measures of profitability and cash flow such as earnings per share (EPS) and cash flow per share (CFPS). Assuming that the price-earnings (P/E) multiple at which the stock trades is unchanged, the buyback should eventually result in a higher share price.