If however the outlook for the firm is poor

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Unformatted text preview: m 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 asymmetric information exist from time to time, firms should maintain some reserve borrowing capacity by keeping debt levels low. This reserve allows the firm to take advantage of good investment opportunities without having to sell stock at a low value and thus send signals that unduly influence the stock price. The Optimal Capita...
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