The Market Reaction to Straight Debt Issues: The Effects of Free Cash Flow

Abstract

In this paper we measure the market reaction to 937 straight debt issues between 1983 and 1993. We find a negative and significant market reaction to a straight debt announcement. In addition, we find that the market reaction to a straight debt issue is directly related to the issuing firm's level of existing cash and inversely related to the issuing firm's investment opportunities.

Investment opportunities, free cash flow, and stock valuation effects of secured debt offerings

“…2 This simple measure of q for investment opportunities has been widely used in previous studies (e.g. Denis, 1994;Barclay and Smith, 1995a, b;Kang and Stulz, 1996;Stohs and Mauer, 1996;Howton et al, 1998;Holderness et al, 1999). 3 Our q variable is the average q for the three fiscal years prior to the announcement.…”

“…Following Lehn and Poulsen (1989), Lang et al (1991), Howe et al (1992), Howton et al (1998), Lie (2000Lie ( , 2002, and others, we define the free cash flow ratio as operating income before depreciation minus interest expense, taxes, preferred dividends, and common dividends for the fiscal year preceding the announcement, divided by the book value of total assets. The mean (median) free cash flow ratio of our sample firms is 0.099 (0.094).…”

“…Jensen, however, notes an exception, referring to the cases in which the proceeds from a debt issue are not used to repurchase stock. Debt issues are expected to increase the free cash flow available to a firm's manager since these issues provide additional cash available to managers to be used at their discretion (Howton et al, 1998). Therefore, the overinvestment problem also potentially exists for secured debt offerings as a result of the increase in the issuing firm's free cash flow from the debt issues.…”

Debt vs. Equity and Asymmetric Information: A Review

“…Johnson (1995) finds significantly positive stock price reactions to debt issue announcements for low-dividend payout firms. Howton, Howton, and Perfect (1998) report significantly negative stock price reactions to announcements of straight debt issues without conditioning on dividend or earnings announcements, and that the stock price announcement is inversely related to investment opportunities (Tobin's Q).…”

Análisis De Los Obstáculos Financieros De Las Pymes Para La Obtención De Crédito Y Las Variables Que Lo Facilitan

“…Esto nos origina un problema de agencia, además de cierta asimetría en la información en la que el mejor conocimiento de los administradores de la compañía les beneficiaría frente a los dueños. No obstante, el incrementar el endeudamiento es un efectivo método para contrarrestar esta situación (Howton et al, 1998), puesto que esto obliga a la empresa a realizar pagos futuros programados.…”