Re: Doug Henwood on SS and equity shares

[dhenwood@xxxxxxxxx (Doug Henwood)]

At 3:38 PM 3/3/96, JSAlbus@xxxxxxx wrote:

>What is the cause and what is the effect?  Are you saying that the markets
>are awash in equity financing that no one wants?  Is it true that
>corporations prefer to borrow money at 8% rather than take equity at zero?
> To what do you attribute this strange preference?

The reluctance to issue stock, both for virgin and seasoned companies, is
well-established in both empirical and theoretical terms. Equity finance
has proved a fairly insignificant source of investment capital in both
developed and developing countries, and both in the present and distant
past.

Why is this? For initial offerings, managers are often reluctant to share a
good thing with outsiders. For seasoned offerings, there is a permanent
depression of the stock price regardless of the quantity offered. As the
standard biz school finance text (Brealey & Myers) puts it, "Economists who
have studied new issues of common stock have generally found that
announcement of the issue does result in a decline in the stock price. For
industrial issues in teh United States this decline amounts to about 3
percent. While this may not sound overwhelming, the fall in market value is
equivalent to nearly a third of the new money raised by the issue." [Cites
are in the text; I'm too lazy to type them.] Another reason is the perverse
signalling effects: for an IPO, the question is, if you're biz is so hot,
why are you sharing a piece of it with me?; for a seasoned offering,
investors often take a stock offering as a sign that management thinks
their share price is overvalued.

Also, the costs of equity offerings are quite high (lawyers, registration
fees, promotion, etc.) - higher than debt, and of course much higher than
internal finance.

> Doug Henwood writes:
>I don't think most US firms are finance-constrained; they don't invest
>more because anticipated profitability doesn't match their absurd real
>hurdle rate of around 11%.
>
>Albus replies:
>And why do they set the hurdle at 11%?  Could it be that they cannot afford
>to invest at a lower rate of return because of the risk and cost of borrowing
>at 8%?

Uh, what? The cost of funds, in real terms, to a blue-chip US firm is
around 3%, and the hurdle rate is 11%. I don't understand your point here.

>And even if it is, so what?  What is wrong with that?  Allow for the
>consideration of something new here.  We don't have to be limited by Karl
>Marx's vision of capitalism.

It's not Marx's vision that's limited, comrade, it's capital's.

Doug

--

Doug Henwood
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