Academic journal article Financial Management

Managerial Discretion Costs and the Acquisition of Capital: Evidence from Forced Warrant Exercise

Academic journal article Financial Management

Managerial Discretion Costs and the Acquisition of Capital: Evidence from Forced Warrant Exercise

Article excerpt

Forced warrant exercise should elicit a stock price reaction only in response to inventory adjustments or unanticipated increases in agency costs. We find evidence of both effects. Firms calling warrants for redemption experience negative abnormal returns on the announcement date. Negative returns are concentrated among firms whose characteristics suggest that the call should have been deferred. We find lower announcement returns among inefficient firms with low leverage--firms for which the agency costs of managerial discretion may be high. All else equal, announcement returns are lower among inefficient firms that invested heavily in the year after forced exercise.

The agency costs of managerial discretion play an important role in the valuation process. Although managerial discretion costs cannot be explicitly measured, we can infer these costs from the market reaction to announcements that signal a change in their magnitude.

Studies of seasoned equity offerings (SEOs) and asset sales have documented a relation between managerial discretion costs and stock returns. In this paper, we examine the market reaction to another capital acquisition event in which managerial discretion costs may play a significant role: forced warrant exercise. Warrant exercise is forced when in-the-money warrants are called for redemption prior to expiration. Similar to asset sales and SEOs, forced warrant exercises bring new capital into firms with varying levels of both project quality and debt capacity. Thus, managerial discretion costs become a potential (though not exclusive) influence on the announcement returns.

In perfect markets, managers should call warrants as soon as they are in the money, in order to expropriate the time premium on the warrants. In the presence of managerial discretion costs, firms with poor investment opportunities or unused debt capacity should defer warrant calls. Forcing exercise and injecting equity into the company is bad news because shareholders fear that the proceeds will be misapplied. The announcement of a warrant call should lead to lower residual returns where non-value-maximizing behavior is more likely. These abnormal returns reflect the costs of managerial discretion that are associated with the unanticipated equity issue.

Our results are consistent with the agency explanation for the market's reaction to forced warrant exercise. We find that the market reacts adversely to the warrant call when the announcement reveals that the firm is either issuing equity when debt capacity exists or planning to invest when it has poor investment opportunities. The negative share price reaction to the announcement is concentrated among inefficient firms with low leverage. High-leverage firms experience lower abnormal returns the more they reduce their total borrowing in the year following the warrant call. Holding the impact of leverage constant, inefficient firms experience lower announcement returns the more they invest. Efficient firms fail to evince a similar relation.

An alternative (though not mutually exclusive) hypothesis to explain stock price reactions to a warrant call is that price movements are due to inventory adjustments by security dealers. We explore this hypothesis, but find that it cannot entirely explain market reactions to warrant call announcements. This result, coupled with the strong relation between announcement residuals and our standard proxies for managerial discretion costs, lends credence to the joint hypothesis that the warrant call conveys new information and that agency costs explain some of the negative stock price reaction.

This paper adds to prior research that documents the impact of agency costs on stock returns. Jung, Kim, and Stulz (1996) examine a sample of companies that announce SEOs and find that the announcement residuals are significantly negative only among firms that chose to issue equity despite having high free cash flow and inferior investment opportunities. …

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