Robert H. Litzenberger

Announcement effects of new equity issues and the use of intraday price data

This paper examines the intraday market response to announcements of new equity issues. For fifteen minutes following the announcement, there is abnormally high volume and a -1.3% average return. There is also a small, but significant, negative average return in the hour before the announcement. Issue size, intended use of proceeds, and estimated profitability of new investment are uncorrelated with the announcement effect. After the issuance of new shares, there is a significant price recovery of 1.5%. This evidence is inconsistent with many theoretical rationales for the negative market reaction to new equity issue announcements.

Determinants of interest rate swap spreads

Abstract This study argues that an interest rate swap, as a non-redundant security, creates surplus which will be shared by swap counterparties to compensate their risks in swaps. This action in turns affects swap spreads. Analyzing the time series impacts of the changes of risks of swap counterparties on swap spreads, we conclude that both lower and higher rating bond spreads have positive impacts on swap spreads. We also derive a risk–spread relation to test if swap counterparties are firms with differential credit ratings. Since the risk allocation between swap counterparties varies over business cycles, hence this factor needs to be controlled. We conclude that (1) similar results hold if the business cycle factor is controlled and (2) swap spreads contain procyclical element and are less cyclical than lower credit rating bond spreads.

Testing Financial Market Equilibrium under Asymmetric Information

We devise tests that distinguish between competitive (Walrasian), fully revealing rational expectations and noisy rational expectations equilibria based on their predictions concerning trading volume around public information signals. Empirical results strongly support the noisy rational expectations hypothesis. This indicates that a significant amount of noise exists (so that private information has value), but not enough to obfuscate entirely the information content of price. Our analysis also indicates that the dispersion of private information across traders has an impact on trading volume, but not on price.

Corporate Investment Criteria and the Valuation of Risk Assets

A normative theory of capital budgeting requires determination of the correct cost of capital for the evaluation and selection of risky investment projects. Since different uses of funds within the firm may involve different degrees of uncertainty, the normative theory should take into account the effects of changes in the composition of the firms portfolio of productive assets on its market valuation. The normative theory must therefore be based on a positive theory of market valuation. The objective of this paper is to develop and test an empirical specification of the positive theory.

On Mean Variance Models of Capital Structure and the Absurdity of Their Predictions

Corporate taxes and default risk are relevant to an understanding of the effect of financial leverage on the total market value of the firm. Recently, Kraus and Litzenberger [6] have examined the implications of taxes and default risk for capital structure decisions in a state preference valuation model. A parameter preference model as distinct from a state preference model may be applied to continuous probability distributions. As the most familiar parameter preference approach, the capital asset pricing model is an obvious alternative approach to incorporate the effects of leverage in a world of taxes and default risks. Given the analysis by Hamada [4] of the effects of taxes in absence of default risk and by Stiglitz [16] of the effects of default risk in absence of corporate taxes, such an exercise would superficially appear to be a trivial extension of their studies. However, this paper presents a “reduction ad absurdum†argument that, in an economy where corporate interest charges are tax deductible and firms issue risky debt, the total market value of a levered firm using the capital asset pricing model is misspecified.

Ordinal Predictions and the Selection of Common Stocks

rates of return, variances of rates of return, and covariances of rates of return among individual securities. Unfortunately, a feasible method of accurately generating the massive information requirements of the Markowitz model has not been developed. Historical measures of mean rates of return and covariances of rates of return among individual securities have been shown to be unstable over time and to be ineffectual in generating ex ante efficient portfolios.1 Sharpe (10] has dichotomized a securitys total risk into its systematic and residual components. A securitys systematic risk denotes the portion of its standard deviation explained by the market, and its residual risk denotes the portion of its standard ieviation unexplained by the market. The maximum gains from diversification will asymptotically reduce the contribution each security makes to the portfolios standard deviation to the systematic risk of that individual security. That is, as the investor increases the number of securities in his portfolio of common stocks, the residual component of the portfolios standard deviation asymptotically approaches its lower limit of zero*

Some Observations on Capital Structure and the Impact of Recent Recapitalizations on Share Prices

This paper discusses two fundamental issues in capital structure theory and analyzes the recent recapitalizations of Phillips and Unocal. It is shown that a value-maximizing capital structure may be inconsistent with shareholder utility maximization and that the Miller debt and taxes equilibrium may be inconsistent with a complete capital market. In spite of these and other unresolved issues, the marketss reactions to the recent recapitalizations of Phillips and Unocal are consistent with the predictions of capital structure theory. Except for small redistribution effects against bondholders, the recapitalizations per se had no positive impact on common stock values.

On the Necessary Condition for Linear Sharing and Separation: A Note

A necessary and sufficient condition for linear sharing rules to be Pareto optimal, as generally accepted by the finance community, is that utility functions be of the equicautious HARA class. We demonstrate that this condition is not necessary for a fixed distribution of initial endowments and derive the necessary and sufficient condition. We show examples of utility functions satisfying our conditions.

A Comparison of Capital Structure Decisions of Regulated and Non-Regulated Firms

Robert H. Litzenberger is Professor of Finance at the Graduate School of Business at Stanford University. Howard B. Sosin is a member of the Technical Staff at Bell Labs and is also an Associate Professor at the Columbia University Business School. The authors acknowledge with thanks the helpful comments of the anonymous reviewers. They are of course (jointly) equally and solely responsible for the contents of the paper.

Portfolio Theory and Industry Cost of Capital Estimates

Under certainty the firms average cost of capital is a directly observable magnitude — the rate of interest. Under uncertainty the firm–s average cost of capital is an ex ante expectational concept which is not directly observable. In a seminal application of their prior theoretical contributions to corporation finance, Miller and Modigliani (M-M) [11] obtained indirect econometric estimates of the cost of capital for electric utility firms. A sample of electric utilities was ideal for an empirical application of the A M-M valuation model which is rooted in the partial equilibrium framework of an equivalent risk class. For other industries where interfirm differences in operating risk are greater, the equivalent risk class assumption would be less appropriate. That is, each firm in a heterogeneous industry may be considered in a unique risk class and the concept of an industry cost of capital would be suspect. Furthermore, the M-M theoretical construct does not provide insights into the relationship among costs of capital of firms in divergent risk classes.