Leverage Ratios, Industry Norms, and Stock Price Reaction: An Empirical Investigation of Stock-for-Debt Transactions

Abstract

In this paper, I extend the stock-for-debt research by investigating whether stock value is influenced by how a firm changes its leverage ratio in relationship to its industry leverage ratio norm. I find that announcement-period stock returns for firms moving "away from" industry debt-to-equity norms are significantly more negative than returns for firms moving "closer to" these norms. This finding is consistent with optimal capital structure theory if industry debt-toequity norms are reasonable approximations of wealth-maximizing leverage ratios.The event study research of security offerings has largely failed to explore how stock prices react when a firm changes its debt-to-equity ratio (DE) in relationship to its industry DE norm.1 This lack of serious regard by event studies for the role of an industry DE benchmark is puzzling given the insight of financial leverage ratio research. This line of research suggests that an industry DE benchmark should prove useful in predicting the direction and magnitude of stock returns that accompany pure leverage-change announcements.In this paper, I am motivated by the notion that an industry DE norm (e.g., median or mean) is a useful benchmark when investors evaluate a stock's true worth. The research hypothesis is that firms moving "closer to" industry DE benchmarks should have a market response that is positive when compared to firms moving "away from" industry DE benchmarks. To test this hypothesis, I obtain a working sample of 338 observations where firms announce public common stock offerings. This sample is distinctive in two respects that are important for achieving the research aim.First, it is distinctive in that the sole purpose of each offering is for debt reduction. Not only are the productive assets not directly altered, but simultaneously 1 As discussed later, an exception is Billingsley, Smith, and Lamy (1994), who focus their examination upon firms that simultaneously issue equity and debt. changing both equity and debt produces a large alteration in a firm's DE. Given the notion that firms operate within target DE ranges, large movements in DEs may be required to detect if the market reacts consistently with the view that an industry DE benchmark is a wealth-maximizing target.Second, the sample is distinctive in its size (n=338). Despite the support by leverage ratio research for the importance of an industry DE benchmark, one can argue that an industry benchmark DE may not always be a good estimate of what is perceived as its wealthmaximizing DE. Consequently, a large sample offers the possibility of overcoming estimation problems if one can assume that errors in estimating become less of a concern as the sample size increases.In support of the research hypothesis, I find that the three-day mean cumulative abnormal return (CAR) of -1.91% for "closer to" firms is less negative than the -3.41% CAR found for "away from" firms.2 The 2 Pure-leverage-decrease studies consisting largely of stockfor-debt transactions (e.g.,

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