CFA Level I · CFA Level I Exam · Capital Structure
A company announces a large issuance of new common shares to fund expansion. Under signaling theory and information asymmetry, the share price reaction is most likely to be:
The share price reaction is most likely negative. Because managers have better information than investors, a new equity issue is read as a signal that management believes the shares are overvalued, so investors lower their valuation when the issue is announced.
- Anegative, because investors may infer managers believe the shares are overvaluedCorrect
- Bpositive, because investors infer managers have found highly profitable investments
- Cunchanged, because financing choices convey no information about value
Explanation
Managers know more than outsiders and are assumed to issue equity when they think it is overvalued. Investors therefore read an equity issue as bad news and mark the price down. The positive-reaction option describes the response to a debt issue or a dividend or buyback, not new equity.
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