BUSI 685 Week 2 DB Forum 1 Example

Discussion Board Forum 1: Thread and Replies

BUSI 685 Financial Management, Discussion Board Forum 1 (thread and two replies)

Thread by [Student Name]

The forum prompt, the company and the classmates are composites standing in for the course's own; the textbook, Scripture and research cited are real, and the requirements follow Liberty's public course guide for BUSI 685.

Thread

The prompt describes a composite software company whose shares trade at 40 times earnings, well above its five-year average, and a chief financial officer who wants to sell $300 million of new stock before the price falls. The board asks whether this is smart finance or a bet against the market. The company has no acquisition planned and holds $180 million in cash, so the money would sit on the balance sheet until a use appears.

Brealey et al. (2017) explain market efficiency in three forms: prices reflect past prices in the weak form, all public information in the semi-strong form and all information in the strong form. Fama (1970), in the review that defined the field, found strong support for the weak and semi-strong forms and less for the strong form, because insiders sometimes have information the market lacks. Under semi-strong efficiency, today's price already folds in everything the public knows, and the chief financial officer cannot know that it is too high unless he knows something the market does not.

Yet firms behave as if they can time the market. Baker and Wurgler (2002) documented that firms are more likely to issue equity when their market values are high relative to book and past market values, and that the effect on capital structure persists for years, so a company's present mix of debt and equity reflects its past attempts to time the equity market. Managers time the market most when they believe they know more than it does.

The two findings fit together once private information is considered. If management believes the price is too high because it knows growth is slowing, then issuing stock transfers value from new shareholders to old ones, and investors, knowing this, often mark the price down when an issue is announced. That makes disclosure the ethical center of the decision. Proverbs condemns the merchant who keeps two sets of weights, one for buying and one for selling, as hateful to God (English Standard Version Bible, 2001/2016, Proverbs 20:23). Selling shares at a price management privately believes is inflated, without disclosing what it knows, resembles using a false weight.

I would advise the board to issue only if the company has a genuine use for the capital, and to disclose fully what management knows about growth. If the main reason is the price itself, the board should recognize that it is betting its own information against the market's and that new investors will bear the cost if management is right.

Reply to Andre

Andre, you argued that the company should issue because a high price lowers its cost of equity. That is true in a narrow sense, but the market's response to issue announcements complicates it. Brealey et al. (2017) explain that a firm's stock price typically falls when it announces a seasoned equity offering, because investors infer that managers think the shares are overvalued. Baker and Wurgler (2002) show that firms issuing at high market values do so systematically, which is exactly why investors discount the signal. The company may therefore raise less than today's price suggests, and the decline also lowers the value of existing shareholders' stakes, which offsets part of the gain from selling high. If the software company has a clear use for $300 million, such as an acquisition already under negotiation, explaining that purpose at the announcement may reduce the discount. Would you still recommend the issue if the stock fell 3 percent on the announcement, as it might for a company with no stated use for the cash?

Reply to Hailey

Hailey, your thread cited research on IPO underpricing to warn that the company would leave money on the table. Ritter and Welch (2002) do describe how firms going public reward first-day investors with considerable underpricing, and they argue that agency conflicts and nonrational behavior explain much of it better than asymmetric information alone. But our company is already public, so its offering is a seasoned issue priced near the current market price, not an IPO priced by underwriters before trading begins. Brealey et al. (2017) note that the costs of seasoned offerings, including underwriter spreads, are generally lower than those of initial public offerings. The more relevant risk for this company is the announcement effect, not first-day underpricing. Your warning would apply strongly if the board were taking a private subsidiary public, which some software firms do with a promising product line. Would your concern change if the issue were sold through an at-the-market program in small amounts over several months? Selling gradually at prevailing prices would avoid a single large offering and might soften the price reaction as well.

References

Baker, M., & Wurgler, J. (2002). Market timing and capital structure. The Journal of Finance, 57(1), 1-32. https://doi.org/10.1111/1540-6261.00414

Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of corporate finance (12th ed.). McGraw-Hill Education.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. https://doi.org/10.2307/2325486

Ritter, J. R., & Welch, I. (2002). A review of IPO activity, pricing, and allocations. The Journal of Finance, 57(4), 1795-1828. https://doi.org/10.1111/1540-6261.00478