On Aggregate Demand for Equity and Announcement Effect of Rights Offers 1

This paper develops a simple model that identifies a fundamental factor, term premium, which appears to proxy for economic/market conditions, and is correlated with the aggregate demand for equity capital raised in stock exchanges. Term premium over 33 years is significantly correlated with the aggregate demand: the coefficient is also stable under different economic conditions. This is a new finding. The paper also identifies three factors correlated with share price changes at the time of seasoned stock rights offerings. The share price changes are positively correlated with (a) Tobins measure of investment opportunity, (b) hot market conditions and (c) economic activities. This paper traces for the first time three sources for the well-documented seasoned stock issue effect. These findings add fresh insights on an investment banking topic, on which conflicting findings about seasoned stock issuance effect have been reported. Key words: rights issues; demand for equity capital; public capital market; asymmetric information; adverse selection; NPV; economic conditions JEL Classification: G12; G24 On Aggregate Demand for Equity and Announcement Effect of Rights Offers 1. Introduction This paper has three objectives. It aims to provide a brief overview of the finance literature on the aggregate demand for equity capital in public exchanges in an effort to suggest a new demand model. It develops a test model based on an idea from Fama and French (1989) to investigate whether a key fundamental factor could be the prime determinant of aggregate demand for equity capital raised in public exchanges. Third, the paper investigates which of the commonly suggested macro-economic and firm-specific factors are significantly correlated with share price changes to seasoned equity issuance. The literature on equity raising activities of listed firms is deficient in that there has been no attempt to model the inter-temporal aggregate demand of listed firms for equity capital. This is an important issue as firms are resorting increasingly to public capital (for both equity and debt) since the financial intermediation process of banks is on the decline. This is especially so in countries where the stock markets, such as that in Malaysia, which are sufficiently developed to cater to the increased demand for public capital. As will be elaborated in a later section, the total equity raised in Malaysias stock market was almost 60 per cent of the total investment outlay in the economy in a recent five-year period compared with a mere 5 per cent 25 years earlier, when the then stock market was not well developed. Further, in this market, there has yet been an investigation of the factors significantly correlated with the share price changes of listed firms when new equity is raised through rights offerings. Unlike in the unseasoned issues markets, there is a paucity of studies that attempt to find factors driving the price changes of seasoned issues. The literature on the price effect of rights announcements suggests a number of factors potentially correlated with price changes. Identifying the key fundamental factor(s) driving the aggregate demand for seasoned equity, and then isolating the significant determinants of the price effect are the modest aims of this paper. The rest of the paper is divided into five more sections. Section 2 is an overview of the sparse literature on demand for equity capital. The price effect literature on shares at the time of rights disclosure is reviewed in Section 3. The research issues are identified in the following section. The findings are presented in Section 5 on the demand model and on the price effect. The paper ends with concluding remarks in the last section. 2. Demand for Equity in Public Market – an Overview The literature on demand for equity is quite sparse although there are few theoretical ideas that have long been the central focus of why firms raise and outlay capital. The availability of positive net present value opportunities is the fundamental reason for the demand for capital, be it debt or equity capital. The Theory of Firm as taught in any standard finance/economic course predicts that a price will be determined in the market place for the firm as the net present value of a firms investment activity when the firm makes a decision to deploy the deferred consumption or for that matter any new capital as investment. The distance between the investment schedule and the market line that cuts the consumption axis is often suggested as the net present value of investment activities. This value is at the center of the important concept taught in finance as the positive net present value, NPV. Obviously firms rasing capital to deploy it on positive NPV projects must therefore increase its value by the amount of NPV. Hence, if equity capital is raised in order to deploy it in a positive NPV project, ceteris paribus, this must increase the share prices. The availability of a profitable investment opportunities to a firm therefore must increase the value of the firm by the amount of the NPV of investments undertaken. However, this has not been directly measured. Two studies reported indirect evidence: stock price  note it is not the volume of demand for equity  increases when profitable capital expenditure plans are disclosed (McConnell and Muscarella, 1988); Ambarish et al., 1987, reported similar finding for firms reporting profitable investment opportunities. These are consistent with the standard predictions of the Theory of Firm about NPV. This straightforward argument about the availability of profitable investments as the fundamental determinant of demand for capital is subject to a number of caveats. Firms may find it cheaper to raise capital once in few years since the costs of raising capital tend to be lower the larger the size of the capital raised. Financial press reports suggest that the cost of raising capital by a firm can be twice as high for a small issue than a large issue, which costs about 1.5 to 2.5 per cent of issue value in the developed share markets: in Malaysia, the cost is 1.5 per cent. Given that profitable investing opportunities are unlikely to be postponed, when it is optimal to raise capital at a later time, it can be argued that other factors than positive NPV may be determining demand. Second, profitable opportunities appear to vary inter-temporally because of phases of a business cycle that determine the incidence of profitable projects. Berkovich and Narayanan (1993), in their analytical framework on capital demand, state that the financing and investment decisions are not only interrelated, but are linked to economic and capital market conditions. It is reasoned that investment opportunities are plentiful during an expansion phase of the economic cycle. Equity raising activities may be higher during such a phase and the demand is likely to be lower during a declining phase of the cycle. Choe, Masulis and Nanda (1993) and Bayless and Chaplinsky (1996) showed evidence consistent with this argument. More rights issues occur in the U.S. as in all other places during periods of economic expansions than during contractions. That study introduced the idea of hot and cold markets to the study of rights. The incidence of rights issuance is higher when the cold stock market has begins to heat up, when the economic expansion is associated with stock price increases: Karajzyck et al. (1990). Tobins (1969) theory also suggests that the replacement value of firms, q, is higher during the economic expansion phase. Several studies have documented that qratios of firms are on average smaller during the phase of economic contractions. Ariff et al. (2000) indicated that the average q-ratio in a market was about 30 per cent lower during the period of economic contraction compared with that in the period of economic expansion. That pattern is noted in many economies. Hence, the q-ratio of a firm can be taken as a measure of the economic conditions and therefore it can be a measure of the availability of profitable investments in an economy over time. However, this suggestion has seldom been tested because of the complexity of measuring accurate q-ratios. Since aggregate demand for equity capital is likely to be conditioned by the (a) availability of investment opportunities as well as (b) costs of raising the capital, it is likely that the interest rate uncertainties  more generally investment yield consideration  may determine demand. This insight is found in Fama and French op cit. : they suggest term spread, the yield difference of Aaa bond and 1-year Treasury, as a key variable determining demand. Chen (1991) shows that term spread is positively related to future economic activities. That is, the higher the spread the more likely is the availability of positive investment opportunities during economic expansion and vice versa. Studying the effect of interest rates on investment timing, Ingersoll and Ross (1992) also showed that an influx of investments, both shelved and current, occurs when interest rate improves. It makes economic sense to delay investments till the time interest rate declines, when the same project may have higher value. Bayless and Chaplinsky op cit. measured the size of the term premiums during hot markets in the U.S. as 1.81 per cent compared with 0.74 during cold markets. These values were significantly different at 0.01 acceptance level. Therefore, the two ideas appear to be connected to investment opportunity, and are also the central concerns of profit maximizing firms. The idea of cost of capital also comes together in this measure of term premium. Macroeconomic Influence: Some studies have isolated three variables affecting individual stock returns (example, Fama and French op cit.). Two of the variables, default premium and term premium, are significantly related to fluctuations in interest rates, while dividend yield affects stoc