Why Do Firms Issue Equity

We develop and test a new theory of security issuance that is consistent with the puzzling stylized fact that firms issue equity when their stock prices are high. The theory also generates new predictions. Our theory predicts that managers use equity to finance projects when they believe that investors’ views about project payoffs are likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. We find strong empirical support for our theory and document its incremental explanatory power over other security-issuance theories such as market timing and time-varying adverse selection. A CENTRAL QUESTION IN CORPORATE FINANCE IS: Why and when do firms issue equity? Recent empirical papers have exposed significant gaps between the stylized facts and theories of security issuance and capital structure, so we seem to lack a coherent answer to this question. Our purpose is to develop a new theory of security issuance that is consistent with these difficult-to-explain stylized facts. One empirical regularity is the genesis of the current debate: Firms issue equity when their stock prices are high. This fact is inconsistent with the two main theories of security issuance and capital structure: tradeoff and pecking order. The tradeoff theory asserts that a firm’s security issuance decisions move its capital structure toward an optimum that is determined by a tradeoff between the marginal costs (bankruptcy and agency costs) and benefits (debt tax shields and reduction of free cash flow problems) of debt. Thus, an increase in a firm’s stock price, which effectively lowers its leverage ratio, should lead to debt issuance. However, the evidence suggests the opposite is true. While CEOs do consider stock prices to be a key factor in security issuance decisions (Graham and Harvey (2001)), firms issue equity rather than debt when stock prices are high (e.g., Asquith and Mullins (1986), Baker and Wurgler (2002), Jung, Kim, and Stulz (1996), Marsh (1982), and Mikkelson and Partch (1986)). Moreover, Welch (2004) finds that firms let their leverage ratios drift with their stock