Capital Structure and Security Issuance Under Heterogeneous Beliefs

Abstract

Using a sample of debt and seasoned equity issues from 1980-2004 and different proxies of investor optimism and the dispersion in investor beliefs, we empirically analyze, for the first time in the literature, the effect of heterogeneous beliefs among outside investors on the capital structure and security issuance choices made by a firm. The paper consists of three parts: In the first part of the paper, we study how heterogeneous beliefs affect a firm's choice between equity and debt for raising external financing; in the second part of the paper, we study the effect of heterogeneous beliefs on the price impact of a security issue on the firm's equity; and in the third part of the paper, we study the effect of heterogeneous beliefs on the long-term stock performance of equity and debt issuers. Our empirical results can be summarized as follows. First, the probability of a firm issuing equity rather than debt is increasing in both the average level of optimism of outside investors and the dispersion in outsider beliefs. Second, the price impact on the firm's equity is negative for an equity issue and zero for a debt issue; further, the price impact of an equity issue is decreasing (more negative) as the dispersion in outsider beliefs is greater. Finally, while the long-term stock returns to both equity and debt issuers is negative, the stock returns to equity issuers is significantly more negative than that of debt issuers. Further, the more optimistic outsiders are on average about a firm's prospects at the time of an equity issue and the more dispersed their beliefs, the more negative the long-term stock returns to the firm. Overall, our results indicate the importance of heterogeneity in investor beliefs as a determinant of the financing decision of a firm.

Keywords: Heterogeneous beliefs, Security Issuance, Price Impact, Capital Structure

JEL Classification: G32, G39