Question

Ronald Masulis analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities. Masulis found that debt for equity exchanges were good news (stock price increased on announcement) and equity for debt exchanges were bad news. (Masulis, 1980)

a) Are these results consistent with the trade-off theory of capital structure? b) Are the results consistent with the evidence that investors regard announcements of (i) stock issues as bad news, and (ii) stock repurchases as good news. c) How could Masulis's results be explained?

Answer 1

a) Yes, the results are consistent with the trade-off theory of capital structure. As per the theory the investors prefer the firm to minimize the weighted average cost of capital (WACC) IF by issuing debt the company is able to minimize its wacc and maximize its value the investors will take the news for exchanging debt for equity as a good news. Also as per the pecking order the investors prefer the capital to be raised through internally generated funds, then through debt and the through equity. So the reaction of the investors in-line with the actions of the firm.

b) i) yes investors do regard news of stock issue as bad news because the firm will generate equity if they do not have reserves/surplus or it cannot generate capital through debt. Equity is the last resort of raising capital and as the cost of equity is generally higher than the internally generated funds and debt, its usually taken as a bad news for the investors. In the pecking order also equity is the last option to be given for generating new equity.

ii) Stock repurchases are taken as a god news because it sends a signal to the market/investors that the firm sees the equity of the firm as undervalues and would like to purchase it because it can be a good investment for the firm. This happens when the firm predicts that it can perform really well in the coming period and the performance will reflect in the stock price. As the investment will give good returns to the firm they will invest in the stock repurchase activity which sends a strong and a good indication to the investors.

c) masuli's result can be explained on the basis of the capital structure of the firm and its debt/equity ratio. The same needs to be compared with the industry peers and to be checked whether we have the optimal capital budget and whether we have the industry ratios maintained as done by the other peers in the industry