Seasoned Equity Issues With 'Soft' Information: Theory and Empirical Evidence

Abstract

We develop a model of seasoned equity issues (SEOs) under asymmetric where, in addition to observing the firm's issue/no issue decision, outsiders obtain information signals about firms through noisy voluntary disclosures made by firms or production by outsiders. We show that, if sufficiently precise soft is available to outsiders, firms' equity issue behavior is significantly altered in equilibrium relative to that in existing models of SEOs. In particular, while existing models predict that the announcement effect to a public offering of equity will always be negative, our model predicts that the announcement effect will be positive for a significant fraction of SEOs. We predict that the announcement effect will be positive or negative depending on the realization of outsiders' soft information, the value of the firm's assets-in-place, and the net present value of its growth opportunities, with firms about which outsiders have more favorable soft receiving algebraically larger (more positive or less negative) SEO announcement effects. We also have predictions for the relationship between the precision of outsiders' soft and the amount of underinvestment in that firm, and for a firm's debt to equity ratio. Finally our model provides a rationale for the existence of investor relations departments in many firms. We test two of the predictions of our model using stock price data of a sample of firms making equity issues, and using revisions in analyst recommendations and earnings forecasts as proxies for the realizations of outsiders' soft signals about these firms. The evidence is consistent with the predictions of our model..