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1

Arguments for raising more capital when overvalued

Catering investors’ expectations
Project scale economies
Investor short-termism

2

1. Sensitivity* to overvaluation is bigger for

Overvalued firms
Growth firms(low B/M or high R&D
Firms with more intangible assets and R&D
Small firms
Firms where investors have short investment horizons
Firms with high insider selling
High turnover firms

3

What about is paper

In this paper authors analyzed how equity overvaluation affects corporate financing decisions by using ex-ante measurement of misevaluation, by sorting out firm’s scale and growth possibilities from the market price.

4

Measurement of equity misvaluation

(V/P=valuation of firm to price)

5

New issues puzzle

the return underperformance after new securities issues, with more severe underperformance after equity issuances than after debt issuances

6

The purpose of research

Authors test whether and why overvaluation causes firms to raise more net capital, especially equity.

7

Hypotheses of research

A firm issues more equity (and debt) when the degree of its overvaluation increases.

The sensitivity of equity issuance to misvaluation is greater (more positive) than the sensitivity of debt issuance to misvaluation.

Overvalued firms will issue more debt and equity than undervalued when the degree of their over/undervaluation increases/decreases.

The sensitivities of total issuance and equity valuation are stronger among growth firms (with low book-to-market ratios).

More intangible assets more equity&debt will firm issue when they are becoming more misvalued.

The sensitivity of equity issuance and total issuance to misvaluation is greater for small than among large firms.

If shareholders have short-time investment horizon, then firms is more sensitive to issue debt & equity when it is misvalued.

8

Findings of the research

o Overvaluation induces firms to raise cheap capital, especially equity
o Equity issuance is greater among firms with high net insider selling
o Even a manager who is focused on increase of long term value of the company will issue more equity when it is overvalued as doing so generates profit for the firm.
o Sensitivity of new issues to misevaluation is higher among high-turnover firms.
o Only overvalued stocks there is the case that equity misvalaluation positively affects new issues.
o Firms that are in lower quintiles of size and book-to-market, and higher quintiles of R&D, have higher sensitivities of equity issuance and total financing to misvaluation.

9

Conclusion of the article

They find that equity issuance and total financing increase with equity overvaluation, simply more firm is overvalued, more equity it will issue. Moreover, they find that equity issuance is more sensitive than debt issuance to misvaluation, thus firms will issue more equity than debt when they are overvalued. The sensitivity of equity issuance and total financing to misvaluation is stronger for firms with: potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover.
Overall the evidence presented in this report supports the proposition that overvalued equity is important for firms’ financing decisions, and is consistent with explanations based upon:
o catering,
o project-scale economies
o investor short-terminism.

10

How equity overvaluation affects corporate financing decision.

Equity issuance and total financing increase with equity overvaluation, but only among overvalued stocks, and that equity issuance is more sensitive than debt issuance to misvaluation.

11

Inefficient market approach inside the paper

a firm will raise more capital, when the share price is above fundamental.