Why Do Firms Issue Equity?

Recent empirical research provides evidence against both the tradeoff and pecking-order theories of security issuance, leaving an important gap in our understanding of why and when firms issue equity. Two explanations are currently in vogue. One is that firms issue equity when their stock prices are high because managers are attempting to time the market and exploit irrational investors and the other is that periods of low information asymmetry happen to coincide with periods of high stock prices. In other words, equity issuances are not driven by financing or traditional capital structure considerations. In this paper, we propose an alternative theory that is consistent with recent empirical findings regarding the relation between stock prices and equity issuance and empirically examine whether our theory has incremental explanatory power relative to the existing explanations. Our theory predicts that managers use equity to finance projects when they believe that investors' views about project payoffs are most likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. Thus, the relation between stock prices and equity issuances occurs because a higher stock price indicates a higher propensity on the part of investors to agree with managerial decisions. We find strong empirical support for our model and discover that it has incremental explanatory power over the market timing and time-varying adverse selection hypotheses in explaining security issuance. Specifically, we confirm that equity is issued when stock prices are high and show that firms with high agreement parameters issue equity regardless of their stock price. We also find that firms that issue equity have significantly higher agreement parameters than firms that do not and that agreement proxies have incremental power in explaining the equity issue decisions beyond timing considerations and proxies for information asymmetry. We further find a significant increase in capital expenditures after equity issues, but not after debt issues, and show that this increase is greatest when investor-manager agreement is the highest. This finding is significant because the other hypotheses imply that the manager will issue equity when the stock price is high, regardless of whether the firm has a project, whereas our theory implies that equity will be issued only to finance a project. In short, we find strong support for our model and show that anticipated shareholder endorsement of corporate decisions is an important driver of when to issue equity.