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Market Reactions to Capital Structure Changes: Theory and Evidence

By John R. Graham, Eric Hughson and Jaime F. Zender


How should the stock market react when a firm issues new equity toretire debt? The traditional view is that, to reflect the loss of debt tax shields, the value of the firm should decline by an amount approximately equal to the firm's marginal corporate tax rate times the amount of debt retired. We argue that the traditional view provides an incomplete analysis of the issue. We construct a simple model of exchange offers and show that quite generally the change in firm value is unrelated to the firm's marginal tax rate. For one parameterization, the change in firm value is exactly equal to the change in dollar amount of debt. Using a sample of over 200 equity-for-debt swaps, we find that the actual market reaction is indeed unrelated to the level of the firm's marginal tax rate. Interestingly, the reaction is statistically indistinguishable from the value of debt retired, as predicted by one version of the model. Within the same framework we develop a test of a dissipative signaling equilibrium of the type described by Ross (1977). If market price reactions are guided by such an equilibrium, the change in firm value, as a percent of the change in the debt level, must be greater the steeper the slope of the firm's tax schedule. The market reaction is found to be inconsistent with dissipative signaling

Topics: Key Words, Capital Structure, Exchange O ers, Debt, Taxes
Year: 1999
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