Equity issues when in distress

Date01 June 2019
AuthorMark D. Walker,Qingqing Wu
Published date01 June 2019
Eur Financ Manag. 2019;25:489519. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons Ltd.
DOI: 10.1111/eufm.12220
Equity issues when in distress
Mark D. Walker
Qingqing Wu
North Carolina State University, 2801
Founders Drive, Raleigh, North Carolina
Email: mdwalker@ncsu.edu
We investigate the role of financial distress in the seasoned
equity market. We find that distressed firms comprise
about 40% of SEOs and these distressed issuers have worse
abnormal announcement returns than nondistressed
issuers. Stock return volatility is an important determinant
for announcement returns for nondistressed SEO issuers
but not for distressed SEO issuers. Signals of firm quality
are associated with better announcement returns, larger
issues, increased investment, improved operating perfor-
mance, and lower likelihood of delisting for distressed SEO
firmsascomparedtonondistressed firms. Our findings
suggest equity finance is valuable for financially distressed
financial distress, SEO
G31; G32
Firms that are in, or near, financial distress face additional costs in obtaining finance. For
distressed firms, raising debt capital may be more costly due to higher interest rates, or in more
extreme circumstances, further credit may simply be unavailable due to prior debt covenants or
unwillingness of lenders to extend further credit. New equity capital has its own additional costs
We are grateful to an anonymous referee and John Doukas (the editor) for their insights and guidance. We also thank
Jesse Ellis, Sean Flynn, Michael Hertzel, Rongbing Huang, Jacob Kleinow, Srini Krishnamurthy, Stephen McKeon,
David Offenberg, Yuri Tserlukevich, and Suyan Zheng for helpful comments. This paper also benefitted from
participantscomments at the 2015 Financial Management Association meetings, the 2015 Eastern Finance Association
meetings, the 2017 Midwestern Finance Association meetings, and at seminars in Virginia Commonwealth University
and UNC Charlotte. All errors are our own.
for distressed firms. An equity issuance for a distressed firm should improve the firms ability to
repay debt thereby increasing the value of outstanding debt. Assuming that new shares are
purchased in the market at a fair price, the increase in debtholderswealth necessarily comes
from the preissuance shareholders, as described by Myers (1977). However, stockholders in
distressed firms also receive benefits from equity issues. Additional equity can increase the
continuation value of the firm, particularly if the firm has valuable projects that need finance.
The firm may also avoid equity issuance costs associated with pecking order considerations. If
debt is less attractive, or unavailable, the negative signal associated with the choice to issue
equity rather than debt will be weaker.
In this study, we provide further evidence on the role of equity finance for distressed firms.
We identify firms that have a higher probability of entering financial distress and choose to
issue equity using both Altman (1968) and Campbell, Hilscher, and Szilagyi (2008). Equity
issues by distressed firms are relatively common. Over our sample period of 19942015, 3,692
SEOs are conducted by industrial firms that meet our data requirements. Of these, 1,450 (39.3%)
have AltmansZscores that categorize them as being financially distressed. Compared to
nondistressed firms, our distressed firms tend to have very poor operating performance, less
working capital, and more debt although not at extreme levels. However, both distressed and
nondistressed SEO groups have high valuations relative to industry peers. These characteristics
are broadly less attractive to creditors, yet the high valuations indicate growth prospects that
would fit more for equity investors. The average abnormal returns for SEO announcements are
worse for distressed firms as compared to the abnormal returns for nondistressed firms. This
finding suggests that the aggregate costs of issuing equity are greater for distressed firms than
for nondistressed issuers.
We next examine these returns in the cross section. The wealth transfer hypothesis implies a
worse (more negative) reaction for those firms that have less ability to meet their debt
obligations. Consistent with this view, we find that the interest coverage ratio has a positive and
significant relation with abnormal returns suggesting that wealth transfers from existing equity
holders to debtholders are important, consistent with prior findings by Elliott, Prevost, and Rao
Stock return volatility is often viewed as a proxy for information asymmetry, which has a
predicted negative relation with announcement returns for SEOs due to overvaluation
This negative impact of information asymmetry should generally be present for all
equity issuers; however, for two nonexclusive reasons, stock return volatility may have
different effects for financially distressed firms. First, a distressed firms stock may have option
like characteristics since the firm has higher probability of entering a default state and an equity
issue may have a meaningful, positive impact on the firms continuation value. As such,
volatility could actually be value enhancing. Second, for distressed firms, although information
asymmetry may affect value negatively in general, there is less new information regarding firm
value associated with the choice to issue equity over debt, since debt is likely less (or not)
available. Therefore, we expect that stock return volatility will be more positive for distressed
firmsannouncement returns either through the channel of greater volatility of future outcomes
or through less impact of information asymmetry.
Our multivariate analysis bears this prediction out for SEOs. High prior stock return
volatility is negatively related to abnormal announcement returns for nondistressed SEO firms,
For empirical evidence, see, for example, Lee and Masulis (2009).

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