LITERATURE REVIEWS
2.5 Evidence of Positive Returns of SEOs
Asymmetric information model of Myers and Majluf (1984), Ambarish et al. (1987) and Cooney and Kalay (1993) and the free cash flow theory of Jensen (1986) predict that the stock price depends on the growth opportunities of issuing firms. The firms with higher growth opportunities should experience less loss than firms with lower growth opportunities at the announcement of equity issue.
If the private placements are issued to a small group of investors, information is expected to be disclosed without fear of leakage to competitors. This reason is argued by Wruck (1989), who made a study in US market. Brealey and Myers (1991) presented also a positive relationship between firm valuation and the Net Present Value, or NPV, of growth opportunities. Later, Denis (1994) discovered that announcement period price changes vary directly with several ex ante measures of growth though it is not monotonic. This discovery is driven by a small subset of high
growth firms whose announcement effects were not significantly different from zero.
However, there was no relation between alternative measures of ex post growth and announcement effects.
In Japan, a study from Cooney, Kato and Schallheim (1996) showed that equity offerings differ from US common stock offerings in two important ways. First, the offering price is determined several days (7 trading days on average) in advance before the subscription period, while the price in US is set less than 24 hours before the offering. Second, the offer prices are set at a considerably deep discount, below the stock’s market value on the offer-price determination day. This puts Japanese underwriter in a position in which it certifies the discounted offer price as the minimum value for the issuing firm’s common stock for the period between offer-price determination day and the day the stock is fully subscribed. Intuitively, underwriter certification at the offer price leads to an upward re-evaluation of the stock price.
The result of event study showed that there is a positive abnormal return for the day before and on the day of board meeting, but result for the day after the board meeting is insignificant. Meaning that, seasoned equity offering causes stock prices to increase. Leakage of information may be the reason to explain why there is a positive return on the day before the board meeting. Anyway, the result is also consistent with increased risk and return around information events, where the event date is known in advance.
There are two ways to determine the offering prices: the fixed price method and the formula price method. The underwriter certification hypothesis fits nicely under this institutional environment because fixed price issues offer more certification.
Average announcement effect for firms using the fixed price method is positive, while the announcement effect is zero for the firms using the formula price method.
Recent study in US by Jiao and Chemmanur (2005) also pointed out that the announcement effect of equity issue will be negative, while the magnitude of the effects varies across firms depending on the extent of information asymmetry facing the firm about asset-in-place and about the NPV of its new projects, for example. However, they hypothesized a significant fraction of firms will have positive announcement effects.
This hypothesis is supported by four main scenarios, all depending on soft information.
First, the announcement effect will be increasing (i.e. more positive or less negative) in the realization of the soft information signals available to outsiders. That is, the model predicts that firms with more favorable reviews in analysts' ratings or earnings forecasts around the equity issue will have larger announcement effects.
Second, the announcement effect will be increasing with higher precision of outsiders' soft information signals. Firms making more precise disclosures will have larger announcement effects. Third, the extent of a firm's underinvestment due to asymmetric information (i.e., cost of capital) will be decreasing in the precision of the soft information signals available to outsiders about the firm. Fourth, the debt to equity ratio of a firm will be decreasing in the precision of the soft information.
A research of Quynh-Nhu (2009) supported the theory proposed by Myers and Majluf (1984), Ambarish et al. (1987) and Cooney and Kalay (1993). They found a positive correlation between issuing firms’ announcement returns and their growth opportunities, and positive market reactions to the announcement of SEO among high growth firms. Findings of Shahid et al. (2010) suggested that market reacts positively to the announcement of right offerings, while public offerings convey negative signals to market.
Elliott et al. (2009) observed that bondholders experience a significant positive return on the announcement of SEO, but this scenario is more articulated on for bonds with lower rating. In fact, bond returns are inversely and negatively related to the bond ratings. With respect to the SEO announcement, there is also a relationship of stock price and the positive excess return to bondholders, but stock price has a limited relationship with information signaling.
In conclusion, the key finding is that SEOs associated with larger changes in leverage are related to positive bond reactions. Just like SEOs, Caton et al. (2011) also shows that issuers tend to inflate earnings performance prior to seasoned bond offerings. When the expected value of new investment opportunities is important relative to the value of assets in place, the stock price reaction could become positive.