The Market Reaction to Warrant Calls: An Agency Cost Explanation

Abstract

A warrant call should only elicit a stock price reaction when there are agency costs of managerial discretion, because in this case the gains to shareholders from expropriating the time premium of the warrants may be offset by the losses when managers invest the proceeds in negative NPV projects. We relate warrant call announcement returns to proxies for the costs of managerial discretion and find support for this argument. We observe lower announcement returns among firms that have low leverage and are inefficient. All other things equal, announcement returns are lower among inefficient firms that invested heavily in the year after the warrant call and among high leverage firms that reduced their debt levels.