shareholders,as opposed to a primary offer where the issuing firm is receiving the proceeds. (And on the subject of ambiguous terms,this chapter will use public ownership to mean stock that is traded in the market,rather than government ownership.Private ownership is used to mean non-traded stock,rather than being owned by the private sector. 2.1 Announcement effects Numerous studies have documented that in the U.S.there is an announcement effect of -2%,on average,for SEOs.The most popular explanation among academics for this negative announcement effect is that of the Myers and Majluf(1984)adverse selection model.Myers and Majluf assume that management wants to maximize the wealth of its existing shareholders in the long run.At any point in time,however,the current market price may be too high or too low relative to management's private information about the value of assets in place.In other words, strong-form market inefficiency is being assumed.If management thinks that the current market price is too low,the firm will not issue undervalued stock,for doing so dilutes the fractional ownership of existing shareholders.If management thinks that the current stock price is too high,however,the firm will issue equity if debt financing is not an option.Rational investors, knowing this decision rule,therefore interpret an equity issue announcement as conveying management's opinion that the stock is overvalued,and the stock price falls.2 How this negative announcement effect should be interpreted is a subject of debate.If a firm is issuing shares equal to 20%of its existing shares,a downward revaluation of 2%for the existing shares is a dollar amount equal to 10%of the proceeds being raised.If this 2%drop is viewed as a cost of an equity issue,then external equity capital is very expensive.On the other hand,if this 2%drop would have occurred when the basis for management's opinion regarding firm value was disclosed in some other manner,then the downward revaluation is not a cost of the equity issue for long-term shareholders.It is a cost only to those shareholders who would have sold their shares in between the equity issue announcement and when the negative news would have otherwise been impounded into the share price.If this is the case,then the negative announcement effect is mainly a matter of indifference to a firm where long-term shareholder wealth maximization is the objective,and external equity is not inordinately costly. As mentioned earlier,when a firm raises external equity capital,it not only conveys information about whether management thinks the firm is overvalued or not,but also suggests that something will be done with the funds raised.If the market interprets the equity issue as implying that a new positive net present value project will be undertaken,the announcement effect could be positive.On the other hand,if the market is concerned that the equity issue means that management will squander the funds on empire building,then the announcement effect could be interpreted as causally linked to the equity issue,in which case external equity is in fact very expensive.The rationale is that the additional equity resources are relaxing a constraint on management's tendency to engage in "empire-building,"or growth for the sake of growth.In other words,agency problems between shareholders and managers are intensified. 2 The Myers-Majluf predictions are very sensitive to the assumptions about the objective function of management, the portfolio rebalancing rules of investors,and the source of information asymmetries.Daniel and Titman(1995) discuss some of these issues in detail. 88 shareholders, as opposed to a primary offer where the issuing firm is receiving the proceeds. (And on the subject of ambiguous terms, this chapter will use public ownership to mean stock that is traded in the market, rather than government ownership. Private ownership is used to mean non-traded stock, rather than being owned by the private sector.) 2.1 Announcement effects Numerous studies have documented that in the U.S. there is an announcement effect of –2%, on average, for SEOs. The most popular explanation among academics for this negative announcement effect is that of the Myers and Majluf (1984) adverse selection model. Myers and Majluf assume that management wants to maximize the wealth of its existing shareholders in the long run. At any point in time, however, the current market price may be too high or too low relative to management’s private information about the value of assets in place. In other words, strong-form market inefficiency is being assumed. If management thinks that the current market price is too low, the firm will not issue undervalued stock, for doing so dilutes the fractional ownership of existing shareholders. If management thinks that the current stock price is too high, however, the firm will issue equity if debt financing is not an option. Rational investors, knowing this decision rule, therefore interpret an equity issue announcement as conveying management’s opinion that the stock is overvalued, and the stock price falls.2 How this negative announcement effect should be interpreted is a subject of debate. If a firm is issuing shares equal to 20% of its existing shares, a downward revaluation of 2% for the existing shares is a dollar amount equal to 10% of the proceeds being raised. If this 2% drop is viewed as a cost of an equity issue, then external equity capital is very expensive. On the other hand, if this 2% drop would have occurred when the basis for management’s opinion regarding firm value was disclosed in some other manner, then the downward revaluation is not a cost of the equity issue for long-term shareholders. It is a cost only to those shareholders who would have sold their shares in between the equity issue announcement and when the negative news would have otherwise been impounded into the share price. If this is the case, then the negative announcement effect is mainly a matter of indifference to a firm where long-term shareholder wealth maximization is the objective, and external equity is not inordinately costly. As mentioned earlier, when a firm raises external equity capital, it not only conveys information about whether management thinks the firm is overvalued or not, but also suggests that something will be done with the funds raised. If the market interprets the equity issue as implying that a new positive net present value project will be undertaken, the announcement effect could be positive. On the other hand, if the market is concerned that the equity issue means that management will squander the funds on empire building, then the announcement effect could be interpreted as causally linked to the equity issue, in which case external equity is in fact very expensive. The rationale is that the additional equity resources are relaxing a constraint on management’s tendency to engage in “empire-building,” or growth for the sake of growth. In other words, agency problems between shareholders and managers are intensified. 2 The Myers-Majluf predictions are very sensitive to the assumptions about the objective function of management, the portfolio rebalancing rules of investors, and the source of information asymmetries. Daniel and Titman (1995) discuss some of these issues in detail