Raising Capital Theory and Evidence

3307 Words Oct 2nd, 2010 14 Pages
Introduction
New information announcements about security offerings by publicly listed firms can cause one of three reactions in the financial markets: (i) positive, (ii) negative, or (iii) indifferent reactions. These responses are measured in the average two-day common stock price reactions adjusted for general market price changes (abnormal returns) to announcements of public issues of common stock, preferred stock, convertible preferred stock, straight debt and convertible debt. Stock markets react to such news by adjusting the market value of the company either upwards or downwards. to take account of the newly announced information.

In 1986, Clifford W. Smith Jr., took note of some very important patterns about the stock market’s
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Earnings Per Share (EPS) Dilution
The first commonly cited argument by financial analysts to explain the above-mentioned findings is that negative adjustments to firm valuations occur as a result of equity offerings that cause short-term reductions of earnings per share, as well as a reduction in the return on equity. The argument is based upon the premise that increasing the number of shares will immediately increase the denominator of the EPS calculation (Net Income less preferred stock/Number of shares outstanding). As such, more shares outstanding equals lower earnings per share.
The assumption is that investors main objective is to maximize their EPS and automatically will reduce their estimates to any issuance of equity. This would seem at odds with modern finance theory as the goal of shareholders is to maximize share price and not necessarily earnings per share. Particularly in cases where investors are cognizant and approving of the use of funds from an equity issuance (i.e. the capital expenditure program is value creating), then the share price would, if anything, rise. Smith quickly dismisses this theory highlighting that the market is far more sophisticated than the implied mechanical reactions to the increase in the number of shares outstanding. Additionally, there is immense difficulty in isolating causality of reductions in earnings per share as

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