Free cash flow

The negative effect on stock prices when firms announce seasoned equity offerings (SEOs) has been extensively documented in the literature (see Asquith and Mullins, 1986; and Jung, Kim, and Stulz, 1996). A number of hypotheses that have been advanced to explain this phenomenon predict a decline in operating performance subsequent to the SEO. Prominent among these are the adverse selection model of Myers and Majluf (1984) and Jensen's (1986) free cash flow theory. Myers and Majluf argue that if managers are better informed than outside investors, firms are more likely to issue equity when the equity is overvalued. Thus, the announcement of an equity offering conveys negative information about firm value. Jensen argues that there are important divergences of interest between managers and shareholders that might induce managers to issue equity and waste funds by taking up negative-net-present-value (NPV) projects. This paper documents the long-term operating performance of firms conducting SEOs, and uses operating performance to examine models of the value losses associated with SEOs.

Our research extends the empirical literature in several ways. First, unlike most prior work that has primarily examined the stock price reaction to equity issues, we examine both the operating performance of SEO firms subsequent to the issue and analyze the determinants of ex-post performance.(1) Second, we examine factors that influence the decision to issue equity and find that higher-leverage firms and high-growth firms have a greater tendency to issue equity. Third, in contrast to earlier studies, our sample includes a large number of firms listed on NASDAQ. These are smaller firms that are more likely to have a larger percentage of firm value in growth opportunities and to have fewer analysts following them. Thus, with greater information asymmetries, these firms are more likely to show the effects predicted by information models.

Our analysis uses a sample of 1,296 industrial firms listed on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and NASDAQ that issued seasoned equity during the 1980-91 period. Consistent with both the free cash flow and Myers and Majluf (1984) theories, sample SEO firms experience significant post-issue declines in cash flow performance in both unadjusted and industry-adjusted comparisons. The median value of this ratio declines by 0.03 during the three-year period following the SEO, which represents a 20% decline in operating performance. Consistent with Jensen's (1986) free cash flow theory, the decline in firm performance is negatively related to the free cash flow in the year before the issue.

The remainder of the paper is organized as follows. Section I discusses prior work on SEOs and develops the hypotheses tested. The sample selection procedure and data used are described in Section II. Section III presents the results of our study, and Section IV concludes the paper.

I. Theoretical and Empirical Background

Two of the most influential theories that explain the negative stock price reaction to SEO announcements are those of Myers and Majluf (1984) and Jensen's (1986) free cash flow theory.(2) In the Myers and Majluf model, managers acting on behalf of existing shareholders have private information about the firm. These managers prefer to issue equity when their shares are overpriced, for example, when they have private information indicating that cash flows are going to fall in the future. In contrast, managers who believe that their stock is undervalued by the market may prefer to abandon valuable projects rather than fund investments by issuing underpriced shares. Hence, examination of the performance of firms conducting SEOs should find both negative abnormal stock price performance for the firm around the announcement of the offer and a decline in firm operating performance subsequent to the offer.

Jensen (1986) argues that there is a serious divergence of interest between managers and shareholders. Managers prefer to retain excess cash flow in the firm and might use the cash for value-reducing activities, such as investment in negative-NPV projects. This problem is especially acute for firms with few positive-NPV investment opportunities. Jensen argues that a major problem for shareholders is to force managers to pay out cash rather than use it for such value-reducing activities.

Capital structure can be one of the means used to constrain managerial behavior. Use of debt reduces the cash flow available for managers' discretionary spending and effectively bonds them to pay out future cash flows. Alternatively, firms can increase their dividends or repurchase their shares. However, unlike bondholders, who have access to bankruptcy court in default, shareholders cannot force the payment of dividends. Thus, Jensen's free cash flow theory predicts that the announcement of SEOs has a negative effect on stock prices because SEOs increase the resources available for poor investment by managers. An empirical prediction of the free cash flow theory is that the change in performance following the equity issue is negatively related to the existing free cash flow. The theory also predicts that as long as the number of positive-NPV opportunities is limited, these firms will experience a decline in operating performance subsequent to issuing equity.

In Miller and Rock (1985), insiders are better informed than outsiders about the future cash flows of the firm. All firms have fixed investment opportunities with diminishing marginal returns. Since the sources of funds (cash flows from operations plus the sale of securities) must equal the uses of funds (investment plus dividends), equity offerings can signal that the firm has realized an unexpected fall in earnings. Thus, the Miller and Rock model also associates announcements of equity offerings with negative stock price reactions and negative changes in performance.

Most of the empirical papers in this area have examined the announcement effect of SEOs and related it to firm-specific variables (see Asquith and Mullins, 1986; Masulis and Korwar 1986; and Brous and Kini, 1994). These papers document that announcements of equity offerings reduce stock prices significantly. However, cross-sectional analysis relating the announcement effect to firm-specific variables has had mixed results. Although Asquith and Mullins find that the size of the offering is statistically significant and negatively related to the announcement-day effect, Mikkelson and Partch (1986) do not find a significant relation. Brous and Kini find a significant positive relation between the announcement period stock price reaction and institutional ownership. This relation is especially important for low-growth firms since these are firms more likely to waste the investment proceeds in value-reducing investment activities. Brous and Kini interpret their findings as support for the monitoring role played by institutions.

Our study builds on earlier work by Healy and Palepu (1990); Hansen and Crutchley (1990); and Patel, Emery, and Lee (1993). Healy and Palepu analyze a sample of 93 large SEO firms by examining changes that occur around SEOs in firm risk, leverage, and earnings levels. They find no evidence of actual earnings changes or changes in analysts' forecasts. However, they do find a significant increase in both asset and equity betas subsequent to the offer. They conclude that the information conveyed by equity offerings pertains to changes in risk, rather than changes in earnings levels. Hansen and Crutchley, on the other hand, find a significant decline in earnings following the SEO for their sample of 109 firms. In contrast to these two papers, our research uses cash flows rather than earnings to measure changes in firm performance pre- and post-SEO and our sample includes 643 NASDAQ-listed firms. Our research also examines additional factors associated with the decline in operating performance.

Patel, Emery, and Lee (1993) examine the long-term cash flow performance of publicly traded firms that issue straight debt, convertible debt, or common stock. Their evidence indicates that prior to the issue, equity issuers and convertible debt issuers perform better than their industries. They also perform better than straight debt issuers. Although Patel et al. find that performance declines subsequent to the issue, these issuers still perform better than their industries. Patel et al. also find that firms with larger offer sizes have greater declines in performance following the issue and offer a signaling explanation for the decline in performance. We focus on a free cash flow explanation of these declines. In addition, we examine factors related to the performance decline and to the decision to issue equity.