The Explanatory Power of Canadian Accounting Measures of Earnings Dilution*

This paper examines the properties of the accounting measures of dilution under pre‐2001 Canadian GAAP. Fully diluted earnings per share (EPS) presents investors with a per‐share figure that attempts to capture the maximum potential dilution that would occur if all dilutive convertible securities were converted and all dilutive stock options and rights exercised. We examine how the difference between basic and fully diluted EPS, which we refer to as the dilutive adjustment, affects the ability of EPS to predict one‐period‐ahead EPS. Moreover, we address the issue of the explanatory power of changes in the dilutive adjustment for unexpected stock returns over the year and at the earnings announcement date. Surprisingly, in contrast with the traditional accounting view that increases in the dilutive adjustment present the investor with bad news due to potential dilution of the future earnings stream, the dilutive adjustment is positively related to next period's earnings and increases in the dilutive adjustment are positively correlated with contemporaneous long‐window stock returns. These results can be attributed to the relation between the dilutive adjustment and the earnings process combined with a partial resolution of the uncertainty attached to growth firms. We find no evidence that investors use information from the disclosure of fully diluted EPS at the earnings announcement date. These results are consistent with increases in the dilutive adjustment capturing the partial realization of a firm's growth potential that more than outweighs the potential dilution attached to the convertible securities; however, this information appears to be already embedded in price prior to the disclosure of fully diluted EPS.     

Convertible calls and corporate taxes under asymmetric information

This paper develops a signalling model of call of convertible securities (bonds or preferred stock) in the presence of corporate taxes and asymmetric information about future earnings. In equilibrium, managers with relatively unfavorable information call to force convertible holders to convert to common stock (in spite of the loss of corporate tax benefits if the convertibles are bonds), while those with relatively favorable information do not call. The model predicts that the announcement period common stock returns are more negative at the call of convertible bond than at the call of convertible preferred stock. Furthermore, we predict that when the importance of the tax deductibility of interest differs among firms, so does the stock price reaction to the announcement of convertible debt call. Specifically, the loss of equity value at the announcement decreases with the amount of non-debt tax shield that the calling firm owns, decreases with the book value of convertible debt called, and increases with corporate taxes.     

Earnings Management and the Long-Run Underperformance of Firms Following Convertible Bond Offers

Abstract:  This paper examines whether the long-run underperformance of convertible bond issuers can be explained by earnings management, as reflected in discretionary current accruals around the time of the offer. Consistent with the earnings management hypothesis, we find that convertible issuers who adjust their discretionary current accruals to report higher net income in the issue year will generally experience inferior operating and stock return performance over the five-year post-issue period. Our findings indicate that there is some temporary overvaluation of convertible issuers by the stock market, but that the resultant disappointed investors will subsequently correct their valuation errors. The similarity of our results to those reported within the prior literature on initial public offers (IPOs) and seasoned equity offers (SEOs) suggests that the earnings management hypothesis is not unique to stock offers, but that it actually extends to convertible bond offers.     

Wealth effects of convertible bond and convertible preference share issues: An empirical analysis of the UK market

We examine the wealth effects of the announcement of issues of different types of convertible securities by UK firms and find significant negative effects on shareholder wealth. We however, also find that when the sample is partitioned by method of issue, privately placed convertible bonds, in contrast to previous research, exhibit a negative impact on firm wealth. Further, we also find negative wealth effects for firms that issue convertible securities to refinance previous debt or finance specific acquisitions. However announcements of convertible bond issues, for the purpose of financing capital expenditure schemes, show significant positive wealth effects. Finally, we find mixed support for testable predictions of the main theoretical models relating cross-sectional firm characteristics of convertible bond issuers to abnormal returns.     

The Consequences of Issuing Convertible Bonds: Dilution and/or Financial Restructuring?

Historically, most convertible bond (CB) issues have been converted to equity sooner or later. The announcement of a CB issue will bring about a future dilution of the firm's capital, and is often followed by a drop in share price. However, a CB issue by itself creates future value for the shareholders if it enables the firm to make profitable investments. It can also issue a positive signal regarding the restructuring of the firm's financial liabilities and its attempts to optimise its financial structure. These positive effects, if they occur, will develop gradually after the issue, and cannot be identified by a simple short‐term event analysis of a CB issue announcement. In this paper, we test the significance of the dilution effect, coupled with a possible value creation effect, using data from the French stock market. We introduce a comparison between dilutive convertibles and non‐dilutive exchangeable bonds. By integrating different corrections and by selecting a window of analysis over a longer period after the announcement of the issue, we show that the negative cumulative average abnormal returns generally observed in previous studies become non‐significant. This absence of global incidence is indicative of large differences in individual behaviour by issuers of CBs, and leads us to take into account the strategic choices linked to the issue of a CB. Two goals, often described as ‘investment financing’ or ‘financial restructuring’, may exist when issuing, and may appear to explain the size of the abnormal returns.     

SOME NEW EVIDENCE ON WHY COMPANIES USE CONVERTIBLE BONDS

The popular argument for convertibles holds that they provide issuers with "cheap" debt and allow them to sell equity at a premium over current value. Objecting to the "free lunch" implied by such an argument, financial economists have offered other explanations that show how the combination of debt and equity built into convertibles can serve to reduce information and agency costs faced by companies and their investors.
In this article, the authors use the results of their recent study to reconcile the two positions. Following Jeremy Stein's view of convertibles as "backdoor equity," the authors argue that convertible bond financing is an attractive alternative for companies that have large growth potential but find both conventional debt and equity financing very costly. Such companies are often deterred from funding their capital investments with straight public bonds by their high risk, relatively short track records, and high expected costs of financial distress. At the same time, the information "asymmetry" between management and outside investors can make equity very expensive in such cases. In layman's terms, management may feel that the company's share price does not accurately reflect its growth prospects, or be concerned that the mere announcement of a new equity offering will cause the share price to fall sharply.
To the extent the stock market is persuaded that management's choice of convertibles is based on this combination of promising growth prospects with limited financing options, it is likely to respond more favorably to the announcement of a new convertible offering. The authors furnish evidence in support of this argument by reporting that the market reacts less negatively to those convertible issuers with higher post-issue capital expenditures and higher market-to-book ratios, but with lower credit ratings and higher (post-offering) debt-equity ratios.     

What Drives the Issuance of Putable Convertibles: Risk-Shifting,Asymmetric Information,or Taxes?

This paper presents the first empirical analysis of firms’ rationale for issuing putable convertible bonds in the literature. We distinguish between three possible rationales for the issuance of putable convertibles: 1) the risk-shifting hypothesis, 2) the asymmetric information hypothesis, and 3) the tax savings hypothesis. The results of our empirical analysis can be summarized as follows. First, putable convertible issuers are larger, less risky firms, having larger cash flows, smaller growth opportunities, and lower bankruptcy probabilities as compared to ordinary convertible issuers. Second, putable convertible issuers have lower preissue market valuations, more favorable announcement effects, and better postissue operating performance when compared to ordinary convertible issuers. Third, putable convertible issuers have better postissue long-run stock return performance as compared to ordinary convertible issuers. Finally, putable convertible issuers typically have greater tax obligations and better credit ratings than ordinary convertible issuers. Overall, the results of our univariate as well as multivariate analyses provide support for the asymmetric information and tax savings hypotheses, but little support for the risk-shifting hypothesis.     

State control,access to capital and firm performance

We study the effect of state control on capital allocation and investment in China, where the government screens prospective stock issuers. We find that state firms are more likely to obtain government approval to conduct seasoned equity offerings than non-state firms. Further, non-state firms exhibit greater sensitivities of subsequent investment and stock performance to regulatory decisions on stock issuances than state firms. Our work suggests that state control of capital access distorts resource allocation and impedes the growth of non-state firms. We also provide robust evidence that financial constraints cause underinvestment.     

THE LONG-RUN PERFORMANCE OF CONVERTIBLE DEBT ISSUERS

We examine the long-run operating and stock price performance of 828 convertible debt issuers. Relative to matched, nonissuing firms, convertible debt issuers have small improvements in operating performance before the offer and significant declines in operating performance from pre- to post-issue. We examine the relation between several factors and operating performance. We find that for some pre- to post-issue periods, operating performance changes are positively related to firm leverage and the callability of the bond, and negatively related to performance run-up before the offer and investment in new assets. We also find some evidence that firms that issued equity in the three years before their convertible debt issue have larger declines in performance after the offer. Relative to matched, nonissuing firms, convertible debt issuers have superior stock price performance before the offer and significantly poor performance after the issue.     

Information spillovers around seasoned equity offerings

We examine information spillovers in the context of seasoned equity offerings (SEOs). Rival firms react significantly positively (0.26%) to primary SEO announcements, indicative of a competitive effect, but negatively (− 0.35%) to secondary share announcements, which is evidence of a contagion effect. Consistent with the view that primary equity offerings signal favorable industry prospects because firms presumably issue new shares to invest in profitable projects, we find that the rival response is positively related to analysts' EPS growth forecasts. However, when insiders are selling their shares through a secondary offer, this may suggest overvaluation and thus negatively impacts rival firms. Consistent with this view, we find when VCs sell through a secondary offerings, rivals experience a more significant negative reaction. We find rival firms are more likely to follow their peers and conduct a primary SEO if the market reacts favorably to their peer's SEO announcement. Finally, rival firms outperform secondary share issuers of equity, but not primary share issuers. Collectively, the findings support the view that insiders take advantage of windows of opportunity when they sell their own shares, but not when they raise capital for investing purposes.     

Information Uncertainty,Earnings Management,and Long‐run Stock Performance Following Initial Public Offerings

We examine how information uncertainty surrounding IPO (initial public offering) firms influences earnings management and long‐run stock performance. For low‐information‐uncertainty issuers, at‐issue earnings’ management is positively related to subsequent unmanaged earnings and has no relationship to market reaction to earnings announcement and long‐run stock performance following the offering. For high‐information‐uncertainty issuers, however, at‐issue earnings’ management is unrelated to subsequent unmanaged earnings and negatively related to market reaction to earnings announcement and long‐run stock performance following the offer. The evidence suggests that, on average, managers in low‐information‐uncertainty firms tend to engage in earnings’ management for informative purposes, while managers in high‐information‐uncertainty firms engage in earnings’ management for opportunistic purposes.     

FIRM PERFORMANCE AND SECURITY TYPE IN SEASONED OFFERINGS: AN EMPIRICAL EXAMINATION OF ALTERNATIVE SIGNALING MODELS

In this paper we examine the long-term performance of publicly traded firms that issue straight debt, convertible debt, or common stock. Declines in firm performance following issuance are consistent with declines in firm value at announcement and issuance, and suggest that convertible debt and common stock are substantially equivalent. This study is consistent with the pecking-order and Miller-Rock models, but inconsistent with the leverage-signaling model. Despite a significant decline following issuance, firms issuing common stock or convertible debt perform better, on average, than the industry before, at, and after issuance. This is consistent with younger, riskier, higher-growth firms being the predominant issuers of common stock and convertible debt.     

Risk and return in convertible arbitrage: Evidence from the convertible bond market

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.     

New evidence on the announcement effect of convertible and exchangeable bonds

This study investigates the announcement and issuance effects of offering convertible bonds and exchangeable bonds using data for the Swiss and German markets during January 1996 and May 2003. The analysis suggests that announcement effects of convertible bonds and exchangeable bonds are associated with significantly negative abnormal returns. German firms exhibit a stronger reaction than Swiss firms, possibly for institutional reasons. We also investigate the effect of the market return of the announcement effect and find that the negative abnormal returns are significantly more pronounced when previous market returns have been negative. Furthermore, we analyze the relation between the announcement effects and equity components by controlling for the equity signal sent to the market. We find the size of the equity component of an issue to have a strong influence on the announcement effect for convertible but not for exchangeable securities and offer an explanation for this difference.     

New evidence on the pecking order hypothesis: the case of French convertible bonds

Convertible bonds (CBs) are an important asset class but their analysis in function of the equity and bond components has received insufficient attention in France. This study investigates the relation between announcement effects and equity components for 141 French CB issues. We use the CB sensitivity to its underlying common stock as a proxy for the equity component. Our results indicate that CB issue announcements imply significantly negative market responses, which are negatively related to the equity component. This result supports the Myers and Majluf (1984) model [Myers, S.C., Majluf, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. J. Financial Econ. 13, 187–221]. A more detailed analysis reveals that the market reaction is significantly positive for the subset of ‘mixed’ CBs. Mixed CB issuers are characterized by high informational asymmetries about investment opportunities compared with informational asymmetries about assets-in-place. This finding supports the revised Myers and Majluf model, which predicts positive announcement effects under certain conditions.     

ON THE INFORMATIONAL EFFECT OF SHORT‐SALES CONSTRAINTS: EVIDENCE FROM THE TOKYO STOCK EXCHANGE

Using a database of stock lending fees for Japanese centralized margin transactions, I show that short‐sales constraints reduce the adjustment speed of stock prices to negative information before the announcements of revised earnings forecasts disclosed by firms in the Tokyo Stock Exchange from July 1998 to December 2001. I find that the cumulative abnormal returns (CARs) of the stocks with high short‐sales costs are insensitive to negative information on pre‐announcement days, but the CARs of these stocks become significantly lower than the CARs of the stocks with low short‐sales costs when the announcements reveal negative information to the public.     

PROFITABILITY, EARNINGS ANNOUNCEMENT TIME LAGS, AND STOCK PRICES

This research addresses (1) whether firms with lower (hgher) than expected earnings fgures released those figures to the public later (earlier) than expected and (2) whether there is a reaction by the capital market to the timing of the earnings announcement. The results indicate that later than expected earnings announcements are likely to contain worse news than early announcements. Also the stock returns of late reporting firms appear to be lower than that of early reporting firms in the days surrounding the earnings announcement date.     

Earnings Management through Transaction Structuring: Contingent Convertible Debt and Diluted Earnings per Share

In this article we examine whether firms structure their convertible bond transactions to manage diluted earnings per share (EPS). We find that the likelihood of firms issuing contingent convertible bonds (COCOs), which are often excluded from diluted EPS calculations under Statement of Financial Accounting Standard (SFAS) 128, is significantly associated with the reduction that would occur in diluted EPS if the bonds were traditionally structured. We also document that firms' use of EPS‐based compensation contracts significantly affects the likelihood of COCO issuance and find weak evidence that reputation costs, measured using earnings restatement data, play a role in the structuring decision. These results are robust to controlling for alternative motivations for issuing COCOs, including tax and dilution arguments. In addition, an examination of announcement returns reveals that investors view the net benefits and costs of COCOs as offsetting one another. Our results contribute to the literature on earnings management, diluted EPS, financial reporting costs, and financial innovation.     

Voluntary disclosure and the cost of equity capital: Evidence from management earnings forecasts

This paper examines the directional effects of management earnings forecasts on the cost of equity capital. We find that forecasters of bad news experience a significant increase in the cost of equity capital in the month after their disclosure. Conversely, the cost of equity capital for good news forecasters does not change significantly in the same period. We also indicate that the magnitude of changes in the cost of capital for good news forecasters is significantly lower than that for bad news forecasters and non-forecasters, which suggests that investors may view good news forecasts less credible. Finally, we show that the effect of the subsequent earnings announcement on the cost of equity capital is preempted by the management forecasts for bad news firms, and that the combined effects of the management earnings forecasts and the earnings announcement are not significant for both good news and bad news forecasters. Our paper contributes to the literature by adding evidence on directional effects of voluntary disclosures and on long-term economic consequences of management earnings forecasts.     

Why do convertible issuers simultaneously repurchase stock? An arbitrage-based explanation

Over recent years, a substantial fraction of US convertible bond issues have been combined with a stock repurchase. This paper explores the motivations for these combined transactions. We argue that convertible debt issuers repurchase their stock to facilitate arbitrage-related short selling. In line with this prediction, we show that convertibles combined with a stock repurchase are associated with lower offering discounts, lower stock price pressure, higher expected hedging demand, and lower issue-date short selling than uncombined issues. We also find that convertible arbitrage strategies explain both the size and the speed of execution of the stock repurchases.