Common Stock Offerings Across the Business Cycle: Theory and Evidence

It is well known that historically a larger number of firms issue common stock and the proportion of external financing accounted for by equity is substantially higher in expansionary phases of the business cycle. We show that this phenomenon is consistent with firms selling seasoned equity when they face lower adverse selection costs, which occurs in period with more promising investment opportunities and with less uncertainty about assets in place. Thus, firm announcements of equity issues are predicted to convey less adverse information about equity values in such periods. Empirically, we find evidence that generally supports these predictions. Consistent with historical patterns, firms in recent times have tended to increase equity more frequently in expansionary periods. While business cycle variables are significant explanatory variables, interest rate variables are generally insignificant. The adverse selection effects as measured by the average negative price reaction to seasoned common stock offering announcements is significantly lower in expansionary periods and in periods with a relatively larger volume of equity financing. These offer announcement effects are less negative for smaller stock offerings and for issuers with less uncertainty about assets in place.