RDP 9610: Share Prices and Investment 5. Share Prices and Financial Decisions
December 1996
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In the previous sections we have tended to concentrate on equity prices as a mechanism by which potential investors evaluate the relative worth of companies based on their earnings capability. However, equity is also a means by which companies raise finance. Over the past decade, equity raisings have accounted for about 30 per cent of the financing requirements of the corporate sector although, over this period, this proportion has been quite variable (Figure 11). In the previous section we concluded that managers are able to distinguish between fundamental and speculative share price movements and that investment decisions are not distorted by the existence of share price inefficiencies. A corollary of these results is that managers should be able to take advantage of any identified mispricing of shares by changing the composition of the firm's financing. For example, if a manager plans to issue equity to finance a new venture and the firm's share price is regarded as undervalued, there would be advantage in delaying the share issue and temporarily funding the project with short-term debt. There is a danger, though, that by their actions managers will indicate their views on the fundamental value of their firm. If this were the case, share prices should decline immediately following equity issue announcements.
Overseas empirical studies tend to support both of these propositions – that firms raise equity when their share prices are overvalued and that share prices tend to fall on the announcement of the share issue.[21]
A casual inspection of real equity raisings and the estimated speculative share price series indicates that managers do appear to actively exploit speculative movements (Figure 12). This relationship is tested by regressing real equity raisings against four lags of the estimates of the fundamental and speculative components of real share prices and a vector of variables which we found to be significant in the investment equations (Equation (12)).[22] Of the vector of determinants of investment only the real return on capital was significant. The coefficients on both the fundamental and speculative components in real share prices are correctly signed and significant at the one per cent level of significance. The implication of these results is that managers not only issue shares when there is a fundamental improvement in their company's share price but that they also take advantage of overvalued share prices (Table 6).[23]
| Quarterly 1982:Q1-1996:Q1 |
|
|---|---|
| Explanatory variables | (12) |
| constant | 3.17* (2.3) |
| ERt−2 | −0.21 (1.8) |
| (π/K)t−1 | 0.88* (2.0) |
 |
0.08** (4.6) |
 |
1.83** (6.9) |
| Summary statistics: | |
 |
0.39 |
 |
0.40 |
| Serial correlation test | 0.14 |
Notes: * and ** indicate the coefficients are significantly different
from zero at the 5% and 1% significance levels. The figures in parentheses are
t-statistics. ‘ |
|
Note: * Five-quarter centred moving average.
The implication of these results and those in the previous section is that managers are able to identify mispricing of their shares. Our results have suggested that while investment decisions are only influenced by fundamental factors (in the absence of other key determinants of investment), equity raising decisions are influenced by both speculative and fundamental factors.
Footnotes
See Fisher and Merton (1984), Korajczyk, Lucas and McDonald (1988), Lucas and McDonald (1989) and Blanchard et al. (1990). [21]
The estimation period is restricted to the 1980s and 1990s because equity raisings were particularly small in the preceding decade. [22]
The unit root test results reported in Appendix B show that real equity raisings is stationary. [23]