ABSTRACT

   We develop and test a new theory of security issuance that is consistent with the puzzling stylized fact that firms issue equity when their stock prices are high. The theory also generates new predictions. Our theory predicts that managers use equity to finance projects when they believe that investors’ views about project payoffs are likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. We find strong empirical support for our theory and document its incremental explanatory power over other security-issuance theories such as market timing and time-varying adverse selection.

   A CENTRAL QUESTION IN CORPORATE FINANCE IS: Why and when do firms issue equity?Recent empirical papers have exposed significant gaps between the stylized facts and theories of security issuance and capital structure, so we seem to lacka coherent answer to this question. Our purpose is to develop a new theoryof security issuance that is consistent with these difficult-to-explain stylized facts.
   One empirical regularity is the genesis of the current debate: Firms issue equity when their stock prices are high. This fact is inconsistent with the two main theories of security issuance and capital structure: tradeoff and pecking order.The tradeoff theory asserts that a firm’s security issuance decisions move its capital structure toward an optimum that is determined by a tradeoff between the marginal costs (bankruptcy and agency costs) and benefits (debt tax shields and reduction of free cash flow problems) of debt. Thus, an increase in a firm’s stock price, which effectively lowers its leverage ratio, should lead to debt issuance. However, the evidence suggests the opposite is true. While CEOs do consider stock prices to be a key factor in security issuance decisions (Graham and Harvey (2001)), firms issue equity rather than debt when stock prices are high (e.g., Asquith and Mullins (1986), Baker and Wurgler (2002), Jung, Kim,and Stulz (1996), Marsh (1982), and Mikkelson and Partch (1986)). Moreover, Welch (2004) finds that firms let their leverage ratios drift with their stock prices, rather than returning to their optimal ratios by issuing equity when prices drop and debt when prices rise. Myers and Majluf’s (1984) pecking order theory assumes that managers are better informed than investors, and this generates adverse selection costs that could dominate the costs and benefits embedded in the tradeoff theory. Firms will therefore finance new investments from retained earnings, then riskless debt, then risky debt, and only in extreme circumstances (e.g., financial duress) from equity. Fama and French (2005) provide two strong pieces of evidence against this theory. First, firms frequently issue stock; 86% of the firms in their sample issued equity of some form during the 1993 to 2003 period. Second, equity is typically not issued under duress, nor are repurchases limited to firms with low demand for outside financing. Between 1973 and 2002, the annual equity decisions of more than 50% of the firms in their sample violated the pecking order. Fama and French therefore conclude (p. 551), “the pecking order,as the stand-model of capital structure alone, is dead.”

Journal of Finance LXXII(1):1-54

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