Custom Search

COSTS OF THE GENERAL CASH OFFER

Whenever a firm makes a cash offer, it incurs substantial administrative costs. Also, the firm needs to compensate the underwriters by selling them securities below the price that they expect to receive from investors. Figure 5.7 shows the average underwriting spread and administrative costs for several types of security issues in the United States.9

The figure clearly shows the economies of scale in issuing securities. Costs may absorb 15 percent of a $1 million seasoned equity issue but less than 4 percent of a $500 million issue. This occurs because a large part of the issue cost is fixed. Figure 5.7 shows that issue costs are higher for equity than for debt securities ¤the costs for both types of securities, however, show the same economies of scale. Issue costs are higher for equity than for debt because administrative costs are somewhat higher, and also because underwriting stock is riskier than underwriting bonds. The underwriters demand additional compensation for the greater risk they take in buying and reselling equity.

MARKET REACTION TO STOCK ISSUES

Because stock issues usually throw a sizable number of new shares onto the market, it is widely believed that they must temporarily depress the stock price. If the proposed issue is very large, this price pressure may, it is thought, be so severe as to make it almost impossible to raise money.

This belief in price pressure implies that a new issue depresses the stock price temporarily below its true value. However, that view doesn`t appear to fit very well with the notion of market efficiency. If the stock price falls solely because of increased supply, then that stock would offer a higher return than comparable stocks and investors would be attracted to it as ants to a picnic.

Economists who have studied new issues of common stock have generally found that the announcement of the issue does result in a decline in the stock price. For industrial issues in the United States this decline amounts to about 3 percent.10 While this may not sound overwhelming, such a price drop can be a large fraction of the money raised. Suppose that a company with a market value of equity of $5 billion announces its intention to issue $500 million of additional equity and thereby causes the stock price to drop by 3 percent. The loss in value is .03 ГЧ $5 billion, or $150 million. That`s 30 percent of the amount of money raised (.30 ГЧ $500 million = $150 million).

What`s going on here? Is the price of the stock simply depressed by the prospect of the additional supply? Possibly, but here is an alternative explanation. Suppose managers (who have better information about the firm than outside investors) know that their stock is undervalued. If the company sells new stock at this low price, it will give the new shareholders a good deal at the expense of the old shareholders. In these circumstances managers might be prepared to forgo the new investment rather than sell shares at too low a price.

If managers know that the stock is overvalued, the position is reversed. If the company sells new shares at the high price, it will help its existing shareholders at the expense of the new ones. Managers might be prepared to issue stock even if the new cash were just put in the bank.

Of course investors are not stupid. They can predict that managers are more likely to issue stock when they think it is overvalued and therefore they mark the price of the stock down accordingly.

The tendency for stock prices to decline at the time of an issue may have nothing to do with increased supply. Instead, the stock issue may simply be a signal that well-informed managers believe the market has overpriced the stock.11

PRIVATE PLACEMENT Sale of securities to a limited number of investors without a public offering.