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Unformatted text preview: view of the firm’s
stock value. Debt financing is a positive signal suggesting that management
believes that the stock is “undervalued” and therefore a bargain. When the firm’s
positive future outlook becomes known to the market, the increased value will be
fully captured by existing owners, rather than having to be shared with new
If, however, the outlook for the firm is poor, management may believe that
the firm’s stock is “overvalued.” In that case, it would be in the best interest of
existing stockholders for the firm to issue new stock. Therefore, investors often
interpret the announcement of a stock issue as a negative signal—bad news concerning the firm’s prospects—and the stock price declines. This decrease in stock
value, along with high underwriting costs for stock issues (compared to debt
issues), make new stock financing very expensive. When the negative future outlook becomes known to the market, the decreased value is shared with new
stockholders, rather than being fully captured by existing owners.
Because conditions of asymmetri...
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