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Unformatted text preview: ue, and thus know whether the equity is undervalued or overvalued
Outside investors observe the market value, but do not know the true value of equity 35 Signaling With Equity If equity is overvalued, then managers will issue equity
If equity is undervalued, then managers will avoid equity issues, and either issue debt or use retained earnings
If the firm issues equity, outside investors will infer that the equity is overvalued, and will not be willing to pay much for that equity, causing a drop in equity prices
If the firm does not issue equity (and issues debt for example), outside investors will infer that the equity is undervalued, and will be willing to pay high prices for that equity, causing an increase in equity prices
Thus, managers can signal that their equity is undervalued by not issuing equity and financing their projects by other means
36 Signaling With Equity: Evidence Empirical regularity: Announcement of an equity issue generally leads to a decrease in the stock price
Similarly, because a firm’s insiders know the firm’s true value but outside investors do not, insiders that sell their shares often send a bad signal
Suppose that Bill Gates one day unexpectedly decides to sell a large fraction of his shares
Investors will infer that Microsoft’s equity is overvalued, causing a decrease in the stock price
Solution: Bill announces that he will sell a small, fixed percentage of their shares every quarter, so that the sale has no information content
37 Adverse Selection & Pecking Ord...
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This document was uploaded on 03/09/2014 for the course COMM 371 at The University of British Columbia.
- Spring '13