Knowledge that Transforms

This paper considers a firm that must issue common stock to raise cash to undertake a valuable investment opportunity. Management is assumed to know more about the firm's value than potential investors. Investors interpret the firm's actions rationally. An equilibrium model of the issue-invest decision is developed under these assumptions. The model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities. The model suggests explanations for several aspects of corporate financing behavior, including the tendency to rely on internal sources of funds, and to prefer debt to equity if external financing is required. Extensions and applications of the model are discussed.

Unlike most securities, the pricing of sinking fund bonds is influenced by the distribution of ownership, which summarizes the extent to which the market is cornered. The effect of the distribution of ownership on the pricing of sinking fund bonds is examined by an explicit game in which the price obtained for bonds sold can depend upon the size of the investor's position. This framework is used to contrast the valuation of sinking fund bonds with the valuation of amortizing bonds and straight debt. We show that it is generally incorrect to view sinking fund bonds as being equivalent to serial bonds.

Past studies indicate that stock prices are affected by announcements of unexpected dividend changes, i.e., unexpectedly large dividends are associated with positive stock price response. Two explanations of this empirical regularity, ‘the information content hypothesis’ and the ‘wealth redistribution hypothesis’, imply different bond price behavior around dividend announcements. The information content hypothesis predicts a positive bond price response to unexpectedly large dividends, while the wealth redistribution hypothesis predicts the opposite. This paper distinguishes between the relative importance of the two hypotheses by empirically investigating bond price behavior around dividend announcements. The evidence presented is consistent with the information content hypothesis. However, the gains associated with positive information are captured by the stockholders, while the losses are shared with the bondholders.

We develop a theory of warrants held by competitive warrantholders not constrained to exercise their warrants as one block; the theory also applies to convertible bonds held by competitive bondholders not constrained to convert their bonds as one block. We prove that the warrant (bond) price in each of the competitive equilibria is less than or equal to the price in an economy with the block constraint; and for at least one competitive equilibrium the warrant (bond) price equals the warrant (bond) price in the block-constrained economy. We illustrate the paths of competitive warrant exercise and bond conversion and conclude that under realistic assumptions they can be long.

Merton (1973) in his seminal article ‘Theory of Rational Option Pricing’ showed that the rationally determined price of a call option is a non-decreasing function of the ‘riskness’ of its associated common stock. In deriving his results, Merton made restrictive assumptions about the way the market prices payoff distributions, and used the Rothschild-Stiglitz (1970) measure to compare the riskiness of securities. I show by means of an example that the Merton result will not in general be true. I then derive a sufficient condition for the option on one stock to have higher market value than the option on another stock, when both the stocks have the same price, and explain why the Merton result is valid in the Black-Scholes environment.