Introduction and issues

This paper investigates the effect of equity issues on stock prices. An enduring anomaly in financial economics is the reliance of firms on internally generated funds as their chief source of equity financing and their corresponding reluctance to issue common stock (Donaldson (1961), Lintner (1960), Sametz (1964)). This behavior is less anomalous to financial practitioners. Financial executives, investment bankers, and many regulators argue that selling equity causes a firm's stock price to fall. Their view, labelled the price–pressure hypothesis by Scholes (1972), contends that an increase in the supply of shares causes a decline in a firm's stock price because the demand curve for shares is downward sloping. The implication is that each firm's shares are unique, and close substitutes do not exist. In addition, some proponents of this hypothesis argue that the price reduction is short–lived and that a post–offering increase in stock prices or ‘sweetener’ is necessary to market additional shares.

In contrast, the theoretical literature in finance assumes that the demand curve for a firm's shares is essentially horizontal. The prices of securities are determined solely by the risk and expected return associated with a security's future cash flows. Close substitutes for a firm's shares, e.g. securities with similar risk and return characteristics, are either directly available in the capital markets or they can be constructed through combinations of existing securities. Moreover, efficient capital markets rule out new issue price effects not based on changes in a security's expected cash flows.