Web Chapter Ii: Financial Market Responses To Capital Structure Changes

WEB CHAPTER II
Financial Market Responses to Capital Structure

Changes
What we Know!
web-capmktresponse.tex: Ivo Welch, 2004.
Confidential: Access by Permission Only!
last file change: Feb 5, 2006 (18:18h).
compile date: Thursday 30th March, 2006 (14:02h).
This web chapter describes in much more detail the empirical evidence of how the financial
markets react to the announcements of managerial capital structure actions. In particular, it
explores how the stock market responds to new equity issues, new debt issues, and dividend
payments. Our goal is to understand better the value consequences of such managerial actions,
which in turn will help us to understand better why managers are doing what they are doing.
129
file=web-capmktresponse.tex: LP
130
Web Chapter II. Financial Market Responses to Capital Structure Changes.
21. Value Changes at Announcements (Event Studies)

Event studies can tell us
whether some actions
are value increasing or
value decreasing...
We will use the event study technique, introduced in the efficient markets chapter, to explore
stock market responses to capital structure announcements. As you recall, an event study
measures the stock returns of firms from just before an event disclosure to just after it, and
attributes the value change to the event. It is a powerful technique, but not a perfect one. To
run an event study, you should be aware of the following issues.
We must to be able to clearly identify when the market learns of the event. Fortunately, we
can identify event dates for three of the most important corporate finance events, which
are the subject of our chapter: seasoned equity offerings, debt offerings, and dividend
declarations. That is, we can usually ascertain quite precisely when firms announce that
they will conduct these activities. Offerings must be filed with the SEC, and dividends are
usually declared during an identifiable board meeting. To avoid insider trading regulations, firms are also usually careful not to disclose their intent earlier.
Unfortunately, there are also many events that might have been interesting but for which
we cannot find a specific event dateand so we cannot use the event study technique for
them. For example, the non-announcement of a dividend has no event date. Employee
compensation related share issuing and share repurchasing are usually done gradually
and so have no sharp event date, either.
We must isolate the events of interest from other important simultaneous announcements.
For example, we know that M&A and capital structure activity can occur together. The
simultaneity can make it difficult to disentangle whether such a stock price change is
in response to the acquisition or the equity issue. If an acquisition has a positive value
impact and an equity offering has a negative value impact, we might even attribute the
incorrect sign to an event.
However, it may not be all that bad, because acquisition announcements often occur before
the acquirer files with the SEC for the new equity financing. If the acquisition has already
been disclosed earlier, it is not news, which thus would not contaminate our event date.
But, it could mean that the market had already expected an equity offering, in which case
the response would be biased towards zerothe offering would be no news.
We must have enough observations to overcome the general noise in stock returns. Fortunately, for each of our three events, we have several thousand event observations over
several years. This is enough to isolate the signal from the background noise in common
stock returns, at least for an overall picture. The drawback is that if we want to find the
response for a small biotech firm involved in DNA technology, the subset of similar firms
may be much smaller. This makes it harder to judge how our specific company will react,
based on the responses of comparable companies.
In sum, even though these three requirements are indeed limiting, they do not prevent us from
exploring in broad strokes how financial markets respond to our three eventsseasoned equity
offerings, debt offerings, and dividend declarations.
file=web-capmktresponse.tex: RP
131
Section 22. Equity Issuing.
22.
Equity Issuing
Our first topic is seasoned equity offerings. Note that all that happens on our event date is that
the firm files its intent to issue equity shares later. The shares themselves will be sold much
later.
22.A. The Average Response
How does the stock price react when a firm files with the SEC for a seasoned equity issue?
Table II.1 gives the answer: the average firm underperforms the stock market by a total of
about 0.994 + 0.630 1.6% on the two days around its announcement. (We do not know
whether the filing occurred after or before the stock market had closed on day 0, so we must
add the two surrounding stock returns.) Thus, our empirical evidence suggests that it is bad
news, on average, when firms announce that they are selling more equity.
Equity offerings are bad

news, on average.
Table II.1. All Equity Filing Date Reactions, 19902000

Event Day
10
9
8
7
6
5
4
3
2
1
Mean
0.246
0.264
0.260
0.231
0.225
0.176
0.197
0.001
0.010
0.126
Std.Dev.
3.81
3.67
3.78
3.59
3.81
3.66
3.89
3.53
3.55
3.52
0
+1
0.994
0.630
4.14
4.52
+2
+3
+4
+5
+6
+7
+8
+9
+10
0.093
0.163
0.166
0.365
0.185
0.200
0.106
0.123
0.045
3.68
3.82
3.53
3.70
3.44
3.51
3.93
3.65
3.60
( T-stat
( 5.0
( 5.6
( 5.3
( 5.0
( 4.6
( 3.7
( 3.9
( 0.0
( 0.2
( 2.8
)
)
)
)
)
)
)
)
)
)
)
( 18.6 )
( 10.8 )
(
(
(
(
(
(
(
(
(
2.0
3.3
3.6
7.6
4.2
4.4
2.1
2.6
1.0
)
)
)
)
)
)
)
)
)
Observations
5,990
5,992
5,992
5,993
5,993
5,994
5,994
5,994
5,993
5,997
5,997
6,004
6,010
6,015
6,020
6,023
6,025
6,028
6,029
6,036
6,038
These are statistics of stock returns on an equal-weighted portfolio of event firms, net of the value-weighted stock
market rate of return, and quoted in percent. The returns are not annualized. In other words, on average, a $100
stock underperformed the market by $0.99 on the announcement day and $0.63 on the following day.
Side Note: The positive average stock return on non-event dates can be explained by the fact that our equity
issuers likely have higher risk (market-beta), and thus have to offer expected rates of return that are above the
markets. If we adjusted the event date return benchmark for this higher riskperhaps an extra 10 basis points
per daywe would consider the underperformance to be about 1.8%, rather than 1.6%.
The 1.6% value loss is highly statistically significant. But how important is it economically?
Economic Significance
132
4
2
etu
ss R
rn
Exce
aily
al D
ative
Cumul
Norm
AboveMarket Return in Percent
Figure II.1. All Equity Filing Date Reactions, 19902000
10
10
Event Day
(A)
2
0
2
4
Excess Return in Percent
This graph shows the mean rate of return (above the value-weighted market rate of return), as in Table II.1. The blue
histogram bars are the daily average returns. The connected line adds them up and is called the cumulative excess
rate of return. This particular sample of firms likely had high betas, meaning that investors expected returns higher
than the market. The graph clearly shows the large underperformance at the event days.
10
10
Event Day
(B)
This graph shows the same data, but gives more perspective. It plots all stock returns on each day, not just the
overall daily means that hide its variability. Each bracket on the right represents mean plus or minus one standard
deviation; each bracket on the left represents the median and the interquartile range (beginning at the first quartile
of the data and ending at the third quartile).
133
On the one hand, 1.6% is more important than it seems at first glance. A $100 firm that
announces that it will issue equity drops by about $1.60. But the typical equity issue is
only about 20% as big as the firms outstanding equity, so the typical issue would be about
$20. This means that about $1.60/$20 8% of the newly raised money is immediately lost.
This effect is often called offering dilutionalthough the term dilution is also commonly
applied to the fact that the issuance of new shares reduces the fraction of the firm held
by previous shareholders.
Because of the statistical properties of ratios, the mean dilution is much higher than 8%.
To illustrate why, compare the ratios of means against the means of ratios in a small data
set.
Obs
X/Y
Y/X
10
100
0.10
10
10
200
0.05
20
20
100
0.20
20
200
0.10
10
Mean
15
150
0.1125
11.25
The dilution is large!
Average dilution is very

high!
The ratios of the means are 0.1 and 10, while the means of the ratios are 0.1125 and
11.25, respectively, in our small data set. This effect also works in our dilution sample.
The average dilution in our sample is about 13.6%, not just 8%. Clearly, an immediate
destruction of wealth equal to 13.6% of the equity being raised is not small. Other studies
have found even larger average dilution effectsas high as 50% in some studies.
This empirical evidence can explain why we see a pecking order, as discussed earlier.
Given how large the dilution can be, it seems rational for firms to try to avoid issuing
equity.
Another win for the

pecking order view of
financing.
On the other hand, you should also not overestimate the importance and general applicability of the 1.6% average value loss. Maybe the market merely learns that existing
projects have turned out to be bad, and the equity offering just release information that
would have had to come out anyway. In this case, the equity offering does not destroy
value, at allin fact, it could even generate value. Without more information, we cannot
dismiss this hypothesis. There is, however, good evidence to suggest that much equity
issuing activity is M&A driven, which makes it more likely that the news is not so much
about a shortfall in existing project, as it is about the future plans of the company.
Perhaps it is about
existing projects, not
wasted money. And
there is much
heterogeneity in
response!
Figure II.1 also shows how easy it is to get the wrong impression from the average stock
return loss. Graph (A) shows the mean rates of return on each day. The graph clearly
shows that the announcement of a seasoned equity offering is not welcome news for
shareholders on average. Graph (B) shows practically the same data, except it represents
the returns from all equity offerings, not just the mean returns. Although it is still evident
that the return on event days 0 and 1 is lower than that on other days, there is still a lot
of heterogeneitymany firms experience positive announcement reactions on the days
that they announce their seasoned equity offerings. The 1.6% loss is highly economically
and statistically significant, but for many firms, it is either drowned out by the daily stock
market noise or positive because the offering adds value. So the evidence is not that all
firms suffer stock declines when they issue equity, but only that the average firm declines
in value. It is perfectly consistent with this evidence for you to believe that your own firm
has too much debt, and that you should issue equity in order to raise the firms value.
Related to this heterogeneity in how firms react is the fact that the median dilution is
only 2.4% of the new equity issue. That is, even though the mean dilution was 13.6%,
half of our firms had dilution of less than 2.4%.
134
Table II.2. Two-Day Equity Issue Announcement Reactions
By Economic Size
Smallest
Largest
Market Cap Itself (in bill-$)
0.2
0.4
0.6
1.2
4.1
Reaction By Market Cap
1.29
1.60
1.74
1.93
1.64
Offer Size/Market Cap Itself
5.4%
11.6%
18.0%
26.5%
47.5% (81%)
Reaction By Offer Size/Market Cap
1.06
1.69
1.89
-2.20
1.37
By Issue Year
Year
1989
1990
1991
1992
1993
1994
Reaction
1.93
1.89
1.38
1.77
1.93
1.55
Year
1995
1996
1997
1998
1999
Reaction
1.17
1.13
1.40
1.84
1.66
Year
2000
2001
2002
2003
Reaction
1.69
1.91
2.02
2.00
The dependent, classified variable is the sum of the announcement day stock returns on day 0 and on day 1, quoted
in percent. The average two day announcement reaction was 1.624%. The economic size (market capitalization
and relative offer size) classifications are based on ranks within the calendar year of the SEO. In my opinion, there is
no clear pattern in these data suggesting that larger or smaller firms (or larger or smaller relative issues) experience
different stock market responses.
22.B. The Cross-sectional Evidence

Smaller firms may or
may not be punished
more when they issue
equity.
Are we able to identify which firms suffer more when they issue equity? For example, do
smaller firms experience more of an announcement decline than larger firms? To answer such
questions, we can add up the event returns on days 0 and 1 for each firm, and call this the
financial markets event reaction. Then we see whether the average announcement drop is
different for larger firms than it is for smaller firms. Table II.2 shows the results.
Firm Size First, we indeed ask whether smaller firms experience different stock market responses than larger firms. We see good dispersion in the types of firms that issue equity,
so we are able to address this question. The smallest quintile of our firms are worth
around $200 million, on average; our largest quintile are worth around $4.1 billion. But
we do not see a clear pattern in the groups announcement returns. The largest firms
experienced a little large drop (1.64%), but so do the next three quintiles. Only the quintile of smallest firms seemed to experience less of a drop (1.29%), but this difference
is modest. Thus, we can conclude that investors of small and large firms respond in a
similar negative manner to SEO announcements.
135
Offer Size Next, we ask whether firms that issued more new equity relative to their already
outstanding market equity value were punished more by the market. Our quintile of
firms with the smallest relative SEO size issued about 5% of the outstanding equity, while
the quintile with the largest relative SEO size issued about 50% of the outstanding equity.
The middle quintile sees a relative increase in firm size of about 18%. But, more important
from our perspective, we do not see a clear relationship between relative offer size and
filing date stock price dropcontrary to what one might have expected before looking at
these data.
No obvious systematic
return difference based
on the relative offering
size or year of issue.
Time Changes Finally, we ask whether the markets punishment has changed over the years.
Table II.2 shows that the announcement price drop was a little less in the mid-nineties,
but has increased again. There is no clear time trend.
No obvious change in
reaction over the years.
In sum, although we know that the market responds negatively to the announcement of an
equity issue, this response does not seem to vary systematically by firm size, issue size, or year
of issue.
Summary
22.C. Earlier Studies

Of course, the above tables are not the first event study of equity issuing announcements. In
the mid 1980s, equity issuing announcement reactions were a prominent area of academic
research. Their samples are a little dated by now, which is why we had to conduct our own
study abovebut the academic studies were done much better and in much more depth. For
example, many of these studies carefully excluded offerings that were filed on days of other
announcements (like M&A). This research generally found similar announcement reactions as
those reported above. The typical equity offering by an industrial company elicited a 3%
announcement response; the typical equity offering by a utility company elicited a 0.75%
announcement response. (Utility companies are regulated and are forced to issue equity fairly
regularly.) Put together, their average abnormal response was about 1.6%, which is almost too
eerily similar to what we found for our sample period. But there is an important difference in
one finding: these studies suggested much higher offering dilution than our 8%. Their offerings
were smaller, but they found that between 30% and 50% of the equity issue value was dissipated
on the announcement day. It is not clear where the difference comes from.
Older studies were

better, but the data are
a bit dated. The findings
were mostly but not
entirely similar.
This research also uncovered a host of other interesting relationships. Lets just look at two.
Equity cancellation is
good. With a previous
run up, an equity
offering is less bad.
1. Firms that experienced a bigger announcement drop upon announcement were more
likely to cancel their equity offering. The cancellation itself was good newsbut not
good enough. Net in net, such companies still ended up worse than if they had never
announced anything in the first place.
2. Firms that experienced large positive run ups prior to the offering and then announced an
equity offering dropped less. That is, they were punished less by the market. This gives
more credence to the market timing explanation for issuing (from the previous section).
It would make sense if managers would be more inclined to issue equity if the penalty is
less.
Digging Deeper:
A good starting point to learn more about the existing academic evidence, on which this
description is based, is the 1986 symposium issue of the Journal of Financial Economics.
Some more recent research has examined how stock prices react not just on the day, but over
the years following a seasoned equity offering. The answers here are less robust, because we
are not really certain as to what the appropriate multi-year stock return should beneither
the CAPM nor any other model that we know is reliable enough to tell us what annual returns
should be in the absence of the issue. Still, the preliminary evidence suggests that the average
abnormal multi-year return is negative, perhaps as large as 5% per annum over four years.
Even more interesting, firms that are unusually aggressive in managing their earnings prior
Equity issuers also

underperform in the
long run, especially
those that were very
aggressive prior to the
offering.
136
to the SEO tend to suffer significantly greater post-equity offering value declines in the years
thereafteran Enron effect, perhaps?
22.D. Theoretical Perspective
We shall assume that
stock price response is
equal to overall value
response.
Does our empirical evidence tell us that equity issues reduce firm value? Not necessarily. We
only know that equity issues are bad news for stockholders. If they were great news for bondholders, then it could be that the overall firm value increased rather than decreased. The
academic literature provides just a few studies of how debt prices respond to equity issues.
This is primarily because most outstanding debt rarely changes hands, and when it is traded, it
is usually not publicly traded but over-the-counter. Thus, researchers cannot learn the trade
prices. (The investment banks that are the counter consider pricing information on bonds
their competitive advantageand for good reasons.) Fortunately, what little empirical evidence
has surfaced in this context and in the context of other events indicates that it is unlikely that
bonds would change much in value when the firm issues equity. Especially highly rated debt
was probably close to risk-free before the equity issue and would remain so after the equity
issue, which would imply that the debt value would not change much upon the announcement.
So, we can make a leap to equate that stock value changes represent most of the overall value
change, and therefore we believe that when the stock price decreases, so does the overall firm
value.
This average reaction is

consistent with a
number of theories
(forces).
With this leap, how does our empirical evidence accord with our theories? (If you do not
remember the theories, look back at Table ?? on Page ??.) Our evidence of an equity issue
announcement drop suggests that any positive effects from reducing personal income taxes,
from reducing financial distress costs, and from reducing debt expropriation among issuers
were outweighed by equitys negative effects. These negative effects can include the extra additional corporate income taxes (due to tilting away from debt), the inside information problem
(managers are not confident about the future, and the market learns this), and the agency problems (managers will have more money to waste). The empirical evidence further suggests that
reluctance of managers to issue equity makes senseit is support for any form of the pecking
order hypothesis.
137
Section 23. Debt Issuing.
23. Debt Issuing

We now turn to the second significant corporate finance event, debt issuing. How does the
stock price react when a firm announces an impending debt issue?
Table II.3 shows that on the two event days surrounding the announcement of a debt issue,
the stock price drop is about 18 basis pointsan order of magnitude lower than that of the
equivalent equity announcement drop. Further, the table shows that there are many days before
and after the debt announcement that have larger stock price responses. Figure II.2 gives even
more perspective by showing how noisy and small the excess returns on the event days are
relative to the mean reaction. So I personally judge this evidence to mean that, on average, a
debt issue is either a very, very, very mildly negative event, or merely a no-event event.
Table II.3. All Debt Announcement Reactions, 19902000

Event Day
10
9
8
7
6
5
4
3
2
1
Mean
0.024
0.157
0.148
0.122
0.122
0.148
0.017
0.069
0.277
0.056
Std.Dev.
1.87
1.93
1.92
1.98
2.10
2.04
2.02
1.97
2.04
1.98
( T-stat )
( 2.1)
(13.3)
(13.1)
(10.4)
( 9.8)
(12.2)
( 1.4)
(5.9)
(22.9)
( 4.8)
Observations
28,422
28,422
28,421
28,424
28,426
28,434
28,425
28,413
28,433
28,433
0
+1
0.129
0.052
2.07
1.94
(10.5)
(4.5)
28,440
28,442
+2
+3
+4
+5
+6
+7
+8
+9
+10
0.098
0.160
0.024
0.146
0.130
0.067
0.065
0.034
0.021
2.06
1.88
1.98
1.96
1.97
1.99
1.93
2.07
2.10
( 8.0)
(14.4)
( 2.1)
(12.5)
(11.1)
( 5.7)
( 5.7)
(2.7)
( 1.7)
28,452
28,455
28,446
28,441
28,441
28,442
28,442
28,441
28,440
market rate of return, and quoted in percent. The returns are not annualized. In other words, a $100 stock on
average underperformed the market by 18 cents on the two days around the announcement.
The drop upon a debt

issue announcement is
small or nonexistent.
138
4
2
0
2
4
Figure II.2. All Debt Filing Date Reactions, 19902000
10
10
Event Day
2
0
2
4
This graph shows the mean rate of return (above the value-weighted market rate of return), as in Table II.3. The blue
histogram bars are the daily average returns. The connected line adds them up and is called the cumulative excess
rate of return. Keeping the same scales as those in Figure II.1 shows how much milder the announcement response
to a debt offering is when compared to an equity offering.
10
10
Event Day
139
Section 23. Debt Issuing.
Table II.4. Two-Day Debt Issue Announcement Reactions
Mean by Market Value

Smallest
Largest
0.8
2.8
7.5
17.0
47.7
By Market Capitalization
0.37
0.09
+0.02
0.27
0.19
Offer Size/Market Cap Itself
0.1%
0.5%
1.3%
3.9%
20.6% (71%)
By Offer Size/Market Cap
0.21
0.15
0.12
0.16
0.28
Year
1989
1990
1991
1992
1993
1994
Reaction
0.21
0.73
0.50
0.44
0.19
+0.10
Year
1995
1996
1997
1998
1999
Reaction
0.36
0.09
+0.10
0.70
0.54
Year
2000
2001
2002
2003
Reaction
+0.30
+0.15
+0.27
0.36
Includes about 1200 Convertible Securities out of 28,000 security offerings. The first two classifications are based
on ranks within the year of issue. The dependent, classified variable is the sum of the announcement day stock
return on day 0 and on day 1. The average announcement response is -0.18%.

Does the 0.17% average necessarily mean that there are no firms that have large negative
or large positive responses? No! It could be that some firms have a very negative response
and other firms have a very positive response. In Table II.4, we check whether we can identify
which firms perform more positively or negatively. We want to see whether larger or smaller
firms respond differently when they announce a debt issue. The first row shows that there is
no evidence to support such a conjecture. All firm size quintiles have announcement returns
that are very small, and there is no consistent relation in how the market responds across
quintiles. The next two rows look at whether the relative issue size matters, and again the
answer is negative. Even the biggest issuers of debt have an announcement price reaction that
is only 7 basis points different from the smallest issuers of debtwhich is not an economically
meaningful difference.
Smaller firms react no

differently from bigger
firms.
140

In contrast to equity issuing activity, debt issuing activity has not seen much study. The few
academic studies of debt issue announcements have tended to document similar results: the
market reaction is either small or nothingand definitely less significant than the market response to an equity issue. There are also no known strong corporate determinants of when
debt issues do seem to solicit a strong value response.
By itself, the average
effect to a debt issue
tells us little.
Because the evidence states that it is mostly neither good nor bad news when the firm issues
debt, by itself, the debt issue evidence has little to say about the theories from Table ??. Netin-net, the total response from the good aspects of debt seems to weigh about equally with the
total response from the bad aspects of debt.
One preliminary
conclusion: Its not just
that we learn that
managers need more
money.
But, together with the earlier evidence on the negative response to equity issues, we can draw
some interesting conclusions. If the market just disliked learning that managers raise money,
we would have expected an equally negative reaction to debt and equity announcements. The
fact that the average stock price response is much more negative for equity issues than for
debt issues suggests that the cause of the bad response is not just that investors learn about a
shortfall in existing projects, which has forced managers to raise more money. If that had been
the case, a debt issue should have elicited as negative a response as an equity issue. Instead, the
market reactions indicate that either investors learn that managers are less optimistic about
the future, or that investors fear that it is the unrestricted nature of equity cash that allows
managers to waste money, as opposed to the restricted nature of debt cash with its imposition
of future discipline.
Cash to managers is bad

news; a higher debt ratio
is good news. This may
explain why a debt issue
is a net zero.
Other studies have explored the market reaction to increases in the firms debt ratio in a much
more clever way. Debt issues and equity issues do two things simultaneously: they can change
the existing capital structure towards more debt or more equity, and they bring money into the
company. How can we determine whether it is the change in the capital structure that matters,
or whether it is the inflow/outflow of cash into the company that matters? The best way is
to look for events in which the company has either kept the capital structure constant while
issuing (i.e., issuing debt and equity in the same proportion as the existing capital structure),
or kept the money in the company constant while changing its capital structure (i.e., issuing
debt to retire the same amount of equity, or vice-versa). As we noted in Table ??, though rare,
such debt-for-equity or equity-for-debt exchanges have occurred. Managers who conduct these
exchange offers are definitely not conveying information that they need more or less money,
i.e., whether their existing projects have fallen short. The empirical evidence that we learn
from such exchanges is clear-cut. Firms that announce that they will soon borrow more to
retire outstanding common stock experience an immediate 10% to 20% increase in the value of
their outstanding stock. Firms that announce that they will soon issue common stock to retire
outstanding debt experience an immediate 5% to 10% loss in the value of their outstanding
stock. For firms undertaking exchanges, moving towards a higher debt-ratio created value;
moving towards a lower debt-ratio destroyed value.
Learning more from the

evidence.
Now put our evidence together. We know that there is a positive effect when the firm increases
its debt ratio, holding constant cash inflows. We know that there is a negative effect when
the firm decreases its debt ratio, holding constant cash inflows. We know that there is a zero
overall effect if the firm issues debt. And we know that there is a negative overall effect if the
firm issues equity. We can therefore conclude that for debt offerings, the positive signal from
the increase in the firms debt ratio must be roughly equal to the negative signal from more
money in the hands of managers; while for equity offerings, both effects are pointing in the
same direction.
141
Section 24. Dividend Payment.
24. Dividend Payment

Finally, we can also look at a payout eventwe repeat our analysis with dividend announcements. How is the stock price affected by the declaration of a dividend? Again, we look at the
announcement reaction at the declaration date, not the reaction at the actual dividend payment
date.
Table II.3 shows that a dividend declaration is associated with a positive announcement price
response of about +0.25%. The magnitude of this response is actually meaningfully largeand
surprisingly so. Dividends are usually much smaller than equity or debt issues. (Think of this
as the flip side of dilution in the context of an equity offering.) Moreover, because they are
so frequent, dividend payments are also more anticipated by investors in the stock marketa
fact implying that our measured event study price announcement response of 0.25% is likely
below the true total dividend market response. Given these two mitigating factors, we would
have expected a smaller announcement reaction.
Dividend
announcements are
good newson average,
though not for each and
every case.
But Figure II.3 shows again that this applies only for the average dividend, not for each and every
one. There is enormous variation in response to dividend announcements. Almost as many
firms experience share price declines on the day of the announcements as firms experience
increases.
There is again large

variation!
Table II.5. All Ordinary Dividend Announcement Reactions, 19802000.

Event Day
10
9
8
7
6
5
4
3
2
1
Mean
0.014
0.015
0.010
0.015
0.021
0.014
0.024
0.015
0.021
0.031
Std.Dev.
2.32
2.33
2.38
2.33
2.34
2.32
2.36
2.31
2.34
2.40
0
+1
0.124
0.119
+2
+3
+4
+5
+6
+7
+8
+9
+10
0.075
0.060
0.054
0.057
0.059
0.049
0.040
0.036
0.025
( T-stat
( 2.8
( 3.0
( 2.0
( 3.0
( 4.2
( 2.7
( 4.7
( 3.0
( 4.1
( 5.9
)
)
)
)
)
)
)
)
)
)
)
Observations
205,693
205,754
205,805
205,829
205,870
205,906
205,954
205,969
206,012
206,036
2.69
2.63
( 20.9 )
( 20.6 )
206,071
206,100
2.40
2.34
2.31
2.29
2.32
2.30
2.30
2.30
2.28
(
(
(
(
(
206,111
206,111
206,132
206,134
206,129
206,130
206,113
206,078
206,029
14.1
11.7
10.7
11.2
11.7
( 9.6
( 7.8
( 7.1
( 5.0
)
)
)
)
)
)
)
)
)
market rate of return, and quoted in percent. The returns are not annualized. In other words, a $100 stock on
average outperformed the market by about 24 cents on the two days around the dividend declaration.
142
3
2
1
0
1
2
3
Figure II.3. All Dividend Filing Date Reactions, 19902000
10
10
Event Day
2
1
0
1
2
3
This graph shows the mean rate of return (above the value-weighted market rate of return), as in Table II.5. The
blue histogram bars are the daily average returns. The connected line adds them up and is called the cumulative
excess rate of return. Unlike debt and equity issues, dividends occur fairly regularly, so even a smaller response
can be economically more important. Strangely, in our sample, the market seems to have taken a few days to
digest the informationthe average returns after the announcement were systematically higher than those before
the announcement.
10
10
Event Day
143
Section 24. Dividend Payment.

Finally we find that the
market responds
differently to
announcements based
on characteristic!
4000
Figure II.4. Perspective Plots
2000
1000
Frequency
3000
0.02 0.04 0.06 0.08 0.10 0.12
Mean=0.243%
Firm Return ValueWeighted Market Return
For both debt and equity offering announcements, we failed to find evidence that the market
responded differently to different firms. Fortunately, Table II.6 shows that we can finally report
some real differences across firms! First, small firms (with an average market value of $30 million) experience a stronger dividend announcement reaction than large firms (with an average
market capitalization of $8.5 billion). This is probably because dividend announcements are
considerably rarer for small firms than for large firmsand any dividend announcements become even better news. Second, the type of dividend declaration matters. Bigger increases in
dividends (current payment minus last payment, all divided by share price today) are greeted
with a more positive announcement reaction. Interestingly, Table II.6 shows that the lowest
quintile here are firms that decreased their dividends, yet the market did not respond too negatively. Chances are that the market had already digested the reason for the dividend cut prior to
the cuts official announcement, and therefore had already lowered the firms value assessment.
(Unfortunately, we can study dividend declines, but it is not as easy to study outright dividend
omissionsbecause we have no clear announcement day when a dividend is not announced.)
The three middle quintiles are basically firms that did not much change their dividends one
way or the other, and their announcement responses are all mildly positive. The largest quintile
are firms that significantly changed their dividend yieldand they are the ones that experience
the most dramatic stock price increases upon declaring the dividend.
10
0
Event Day
10
15
10
10
15
20
Event Days 0+1, Announcement Return

The academic literature on dividends is voluminous. Depending on the type of dividend studies,
even stronger effects than those we documented above have been found. For example, a firm
that pays dividends for the first time is generally greeted with a response of roughly 3% to 4%.
Some studies have found bigger effects than our +0.243%: an ordinary dividend increase may
generally be greeted by a stock price response as large as 1%; and a dividend decrease may
generally be greeted by a stock price response as low as 2% to 3%.
Dividend initiations
show stronger effects.
As we discussed in Section ??, share repurchases are substitutes for dividends. They tend to
be greeted with a roughly equally strong positive response as dividends of equal size (although
repurchases tend to be bigger). So, over the same time period, the immediate announcement
price reaction of an open market share repurchase program was around 2% on a single day.
The very largest share repurchase programs, called intra-firm tender offers, usually commit to
repurchasing a considerable fraction of the firm and are greeted by a much more positive market response (10% to 20%) than the announcement of run-of-the-mill open market repurchase
programs.
Share repurchases show

similar effects as
dividends.
144
Table II.6. Two-Day Dividend Declaration Announcement Reactions
By Market Cap Group:

Smallest
Largest
0.03
0.10
0.26
0.80
8.52
Reaction By Market Cap
0.373
0.247
0.256
0.200
0.137
Change in DivYld Itself
0.19%
0.00%
+0.00%
+0.00%
+0.13%
Reaction By Change in DivYld
0.045
0.172
0.214
0.145
0.601
Year
1980
1981
1982
1983
1984
Reaction
0.24
0.32
0.18
0.35
0.15
Year
1985
1986
1987
1988
1989
Reaction
0.16
0.15
0.21
0.28
0.08
Year
1990
1991
1992
1993
1994
Reaction
0.15
0.22
0.41
0.34
0.28
Year
1995
1996
1997
1998
1999
Reaction
0.23
0.19
0.30
0.03
0.03
Year
2000
2001
2002
2003
Reaction
0.47
0.43
0.46
0.33
The dependent, classified variable is the sum of the announcement day stock return on day 0 and on day 1, quoted in
percent. The average two day announcement reaction was +0.243%; its standard deviation is 3.62%. The economic
size (market capitalization and dividend yield change) classifications are based on ranks within the calendar year of
the SEO. The dividend yield change is dividend delta, normalized by the current price; it is therefore not the change
in dividend yield.
Digging Deeper:
Reaction
We can also run a regression, rather than report group means.

=
0.70
(T = 13.14)
+ 35.44 (Dividend Yield) 0.037 log(Market Cap)

(T = 22.60)
(T = 8.78)
(II.1)
R 2 = 0.29%
This confirms that changes in dividend yields and firm size matter. Other factors tested (but not reported) played
much lesser roles.
Section 25. Interpreting The Empirical Event Study Evidence.
145

So why did stock values increase when dividends were declared? If Modigliani-Miller are right,
a dividend just shifts money from one pocket of the investor (the firm) into the other pocket
(the private account). It must be that increasing dividends sends a signal that helps investors
assess the firms future more favorably. Looking back at Table ??, you will see that the theories that immediately come to mind as consistent with our empirical evidence are that either
investors learned that the firm was more profitable than they thought (inside information), or
that managers have decided not to waste good earnings on pet projects and perks but instead
to return money to investors (agency). The evidence also suggests that the personal tax disadvantages of dividends were outweighed by the positive dividend theorieseven when they
were still theoretically important, as they were in our sample period, which ended before the
Bush tax cuts of 2003.
The evidence reflects on

the theory: dividends
are good news, so tax
wasting costs must be
lower than investor
gains.
There is one interesting aspect in interpreting our evidence in light of the theories, though. For
the most part, the payment of dividends does not seem to increase bankruptcy costsor we
should have seen a decline in firm value. The wrinkle is that for the firms that are reducing
dividends, the stock price did not decline. There are two possible explanations. The first is
that despite the cut, dividends remain higher than the market had expected (good news). The
second is that the cut in dividends reduced bankruptcy costs, a positive event, which thereby
mitigated an otherwise negative dividend response.
What might the evidence

for firms cutting
dividends mean?
25. Interpreting The Empirical Event Study Evidence

The event study evidence, on average, can be summarized as follows:
Our findings
summarized now.
When firms pay out money, it is good news; when firms raise more money, it is neutral or
bad news.
When firms increase their leverage ratio (holding size constant), firm value increases; when
firms decrease their leverage ratio, firm value decreases.
When firms raise money through debt rather than through equity, these two effects just
about cancel one another.
When firms raise money through equity rather than through debt, both effects work in
the same direction, which is particularly bad news.
The last two empirical regularities also go well with the pecking order hypothesis and the
empirical evidence that firms raise equity rarely, and debt more frequently.
On average, the empirical evidence is thus favorable to theories that suggest that more money
and especially more equity money in the hands of managers is bad. It is not easy to interpret
these facts in light of our theories, because the empirical facts are the outcome of many forces.
Our facts can primarily tell us only which theories seem to have stronger effects on average, and
which theories seem to have weaker effects on average. Moreover, our findings apply primarily
to our sample of publicly traded firmsand often very well-capitalized firms:
Agency: yes. More free cash seems to lead managers to waste more.
Corporate Taxes: yes. Lower leverage ratios may reduce the corporate income tax shelter, and
thus contribute to a decline in value.
Personal Taxes: no. The importance of personal income taxes on dividends seems to be not
too high, given that the average dividend announcement response was positive.
Bankruptcy Costs: mostly no. On average, financial distress costs seem not to be important.
The raising of more money did not increase firm value, but decreased it. (The exception
is that we do not see a big announcement price drop when firms reduce dividends. This
Our interpretations
summarized now.
146
may indeed be because these are the firms in distressthe market already knows about
the trouble and a dividend cut may be a necessity.)
Inside Information: yes. More equity seems to be bad news. It may signal managers trouble
with a current earnings shortfall and/or lack of faith in the future.
Two other factors are difficult to test, because good empirical tests would have to rely more on
data that we typically do not have.
Debt Expropriation: unknown. This hypothesis is consistent with the fact that the stock market responds more negatively to an equity announcement than to a debt announcement.
To test this hypothesis would require knowledge of how the value of corporate debt
changeswhich would rely on data that we typically do not have, because corporate debt
is often either traded rarely, or primarily over the counter. My own opinion is that debt
expropriation is rarely an important factor, except in the most distressed firms.
Transaction Costs: unknown. Transaction costs are not easy to measure. Some direct costs
may be known; indirect transactions costs (e.g., time) are much more difficult to describe.
However, models of even modest transaction costs suggest that they have the potential
to explain a good number of empirical issues we do not yet fully understand.
Again, you should always keep in mind that our evidence is about the average importance
of these factors. A different set of factors may be important for every firm contemplating a
transaction.
Solve Now!
Q II.1 What are common limiting factors in applying the event study technique to other managerial actions?
Q II.2 Do financial markets respond more positively to stock issues or debt issues? How do the
two events compare?
Q II.3 Is the mean dilution or the median dilution bigger? Why?
Q II.4 Why is the negative 1.6% price drop upon the announcement of an equity offering not
small?
Q II.5 Does the 1.6% response suggest that firms should not issue equity?
Q II.6 How do firm size, offer size, and year of issue correlate with the debt and equity announcement effects?
Q II.7 Why would you expect a small response to a dividend declaration that is not an initiation?
Q II.8 What factors seem to matter in determining how firms respond to dividend announcements?
Q II.9 Can you interpret the evidence that debt issues are just about zero-events and equity issues
are very negative events from the perspective of the role of changes in payout vs. changes in
debt-equity ratio?
Section 26. Summary.
147
26. Summary
The chapter covered the following major points:
When firms announced new seasoned equity offerings, their stock prices dropped by about
1.5% on average. This corresponded to a mean dilution of about 14% of the money raised
by the issue. (Some earlier studies have reported estimates as high as 30-50%, but the
median dilution is undoubtedly much smaller than 10%.)
When firms announced new seasoned debt offerings, their stock prices dropped by a very
small amount (perhaps 15 basis points) on average.
These two reactions can be explained by the fact that raising cash lowers the firms value,
while raising the debt-equity ratio increases the firms value. For debt issues, the two
effects roughly offset one another. For equity issues, they add up.
When firms declared dividends, their stock prices increased by about 25 basis points
which is large, given the usually small amounts of dividends paid and the fact that many
dividend announcements are regularly paid and thus highly anticipated.
The quintile of firms that raised their dividend yields most (by 13%) saw its stock prices
increase by as much as 60 basis points. The quintile of smallest size firms saw its stock
prices increase by about 37 basis points.
These results, together with the evidence from the previous chapter that firms are reluctant to issue equity, are generally consistent with a pecking order view. In turn, a pecking
order can be caused by a number of factors, e.g., by inside information, and by agency
considerations, although some other theories (such as downward sloping demand curves
for stock) are also consistent.
There is a lot of variation in how the market responded to any of these announcements.
Even for the event with the most dramatic average response (equity issuing activity), many
firms experienced positive rather than negative stock price reaction on the day of the
announcement.
148
Solutions and Exercises
1. The identification of the event date, the isolation of the event date, and the availability of enough observations
to overcome stock return noise.
2. Debt issues are associated with just about a zero response (a tiny value drop, less than 20 basis points, on
average). Equity issues are associated with a large price drop, about 160 basis points.
3. The mean dilution. See Page 133.
4. Because of dilutionofferings are usually not to double the firm, so in terms of the offering size, the 1.6%
can represent quite a drop.
5. Only on average! For an individual firm, the response might be positive, because an equity issue might create
value.
6. They do not, at least not very strongly.
7. Because it is expected, so it is unlikely to be much news. In addition, the amounts paid out are often relatively
small.
8. The change in the dividend yield, and the firm size.
9.
It appears that both increases in debt-equity ratio and increases in payout improve firm value. These two
effects offset one another for debt issues, and go in the same direction for equity issues.
(All answers should be treated as suspect. They have only been sketched, and not been checked.)

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WEB CHAPTER II

Financial Market Responses to Capital Structure

Web Chapter II. Financial Market Responses to Capital Structure Changes.

21. Value Changes at Announcements (Event Studies)

Section 22. Equity Issuing.

Equity offerings are bad

Table II.1. All Equity Filing Date Reactions, 19902000

Web Chapter II. Financial Market Responses to Capital Structure Changes.

AboveMarket Return in Percent

Figure II.1. All Equity Filing Date Reactions, 19902000

Excess Return in Percent

Section 22. Equity Issuing.

The dilution is large!

Average dilution is very

Another win for the

Web Chapter II. Financial Market Responses to Capital Structure Changes.

Table II.2. Two-Day Equity Issue Announcement Reactions

Market Cap Itself (in bill-$)

Reaction By Market Cap

Offer Size/Market Cap Itself

Reaction By Offer Size/Market Cap

22.B. The Cross-sectional Evidence

22.C. Earlier Studies

Older studies were

Equity issuers also

Web Chapter II. Financial Market Responses to Capital Structure Changes.

This average reaction is

Section 23. Debt Issuing.

23. Debt Issuing

Table II.3. All Debt Announcement Reactions, 19902000

The drop upon a debt

Web Chapter II. Financial Market Responses to Capital Structure Changes.

AboveMarket Return in Percent

Figure II.2. All Debt Filing Date Reactions, 19902000

Excess Return in Percent

Section 23. Debt Issuing.

Table II.4. Two-Day Debt Issue Announcement Reactions

Mean by Market Value

Market Cap Itself (in bill-$)

Offer Size/Market Cap Itself

By Offer Size/Market Cap

23.B. The Cross-sectional Evidence

Smaller firms react no

Web Chapter II. Financial Market Responses to Capital Structure Changes.

23.C. Earlier Studies

Cash to managers is bad

Learning more from the

Section 24. Dividend Payment.

24. Dividend Payment

There is again large

Table II.5. All Ordinary Dividend Announcement Reactions, 19802000.

Web Chapter II. Financial Market Responses to Capital Structure Changes.

AboveMarket Return in Percent

Figure II.3. All Dividend Filing Date Reactions, 19902000

Excess Return in Percent

Section 24. Dividend Payment.

24.B. The Cross-sectional Evidence

Figure II.4. Perspective Plots

0.02 0.04 0.06 0.08 0.10 0.12

Firm Return ValueWeighted Market Return

Event Days 0+1, Announcement Return

24.C. Earlier Studies

Share repurchases show