Executive Summaries

Executive SummariesSource: Financial Management, Vol. 21, No. 4 (Winter, 1992), pp. 8-15Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665831 .

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Executive Summaries

Order Flow, Trading Costs and Corporate Acquisition Announcements

The bid-ask spread is an important element of investors' transactions costs. Theoretical papers decompose the spread into adverse selection, inventory cost, and order processing cost com-

ponents. The order processing cost component compensates the stock exchange specialist for providing immediacy to buyers and sellers. The inventory cost component compensates the specialist for the risk of holding an inventory of a stock. The inventory component is larger for high-priced stocks, stocks which trade

infrequently, and stocks with a relatively uncertain value. This study focuses on the adverse selection component of the spread, which compensates the specialist for losses to traders who have inside information. Prior theoretical work suggests that the adverse selection component will be larger, the greater the propor- tion of traders who have private information. The specialist will widen the spread in response to a perceived increase in the

probability that the next trader is privately informed. Prior studies also suggest that privately informed traders will generally trade

larger amounts than uninformed traders. Consequently, trade size should impart information about the probability that a trader is

privately informed. The preceding discussion suggests that spreads should in-

crease during periods in which the specialist suspects increased

trading by the privately informed. In this paper, daily spreads of NYSE firms are examined around acquisition announcements to test for evidence of increased adverse selection. The typically large price effect of acquisition announcements gives insiders a

strong motive to trade on their information. We also examine the behavior of trading volume, average order size, number of transactions, and stock returns around the acquisition announcement. In addition, we conduct cross-sectional tests of the relation between the daily change in spread and the daily change in order size around the announcement. If the period immediately preceding the announcement is characterized by increased insider trad-

ing, we expect the change in spread to be more positively related to changes in average order size during this period than during nonevent periods. Our major results are outlined in the following discussion:

Trading volume increases significantly three days prior to the acquisition announcement, with further increases one

day prior to the announcement and on the announcement day. Our results show that about 30,000 more shares change hands on day -3 than during non-event periods, rising to 462,000 shares more than usual at the announce-

ment. This volume increase is largely due to an increase in the number of transactions, since we do not observe a significant increase in average transaction size. We con- clude that the evidence does not support the existence of a small number of investors with private information trading large quantities prior to the acquisition announcement; rather the volume increase is due to a larger number of average-sized orders.

* We find little evidence of increased spreads prior to the acquisition announcement. Instead, we observe a persis- tent decline in the level of the spread (averaging about five cents lower than normal), which coincides with a dramatic increase in trading activity, at and after the announcement.

* In the cross-sectional tests, we observe a positive overall relation between change in spread and change in average order size, consistent with the presence of adverse selection during normal trading. However, this relation does not become more positive during the acquisition announcement period.

Trading volume and the cost of transacting are significantly affected by the announcement of an acquisition. However, none of our results suggest that there is an increase in adverse selection around the acquisition announcement that can be detected using daily data. Neither spread nor average order size increase significantly, nor does the cross-sectional relation between change in spread and change in order size increase significantly during this period.

Our results have implications for the optimal timing of stock

purchases and sales by uninformed investors. Those who trade when average transaction size is abnormally high face higher transactions costs. Though uninformed investors obviously should try to avoid trading a firm's stock during periods surrounding major disclosures, the increase in adverse selection around acquisition announcements (if any) appears to be an intraday phenomenon that dissipates quickly. Two caveats accompany these recommendations, however. First, investors nevertheless appear to be transacting on knowledge of the acquisition prior to public announcement, as evidenced by the significant increase in trading observed in the preannouncement period. Second, our results are based on daily data for a small sample of acquisitions announced during a single calendar year.

Jennifer Conrad and Cathy M. Niden

8



EXECUTIVE SUMMARIES 9

A Market Microstructure Explanation of Ex-Day Abnormal Returns

Several authors have previously determined that abnormal returns exist on ex-cash dividend days and ex-stock dividend

days. In other words, stocks do not, on average, fall by the dividend amount, or fully adjust to stock distributions on ex-days. This paper proposes that NYSE Rule 118 and AMEX Rule 132 are a determinant of those ex-day abnormal returns.

Suppose that an investor places a limit order to buy stock at a

specified price of $49.875 per share. If that order remains unfilled at the opening of ex-dividend day trading, the specified limit price is automatically reduced by the dividend amount. If the resulting price is not an exact multiple of $0.125, then it is rounded down to the next lower multiple of $0.125. For example, if the ex-dividend amount is just one penny (or any amount less than or equal to 121/2 cents), the investor's limit buy order is reduced to $49.75 per share. Any dividend greater than 121/2 cents and less than or

equal to 25 cents causes all limit orders to buy to be reduced by 25 cents per share. In contrast, the prices specified by limit sell orders are not affected. Unless the investor deliberately tells his or her broker, "do not reduce," NYSE Rule 118 and AMEX Rule 132 dictate that specialists handle limit orders in these ways on ex-cash dividend days.

The two exchange rules also define how limit orders are to be handled on ex-stock distribution days. For example, on the ex-day of a one percent stock dividend for a stock trading on the NYSE or the AMEX, the prices specified in all limit orders to buy are divided by 1.01, and then rounded down (if necessary) to the next lower multiple of $0.125. Limit orders to sell NYSE-listed stocks are not affected by stock distributions. However, the prices specified by limit orders to sell AMEX-listed stocks are reduced; like limit buy orders, they would be divided by 1.01 and then rounded down.

Many of the results in this paper indicate that these rules affect ex-cash dividend day returns and ex-stock dividend day returns. One implication of the rules is that the average ex-day return for cash dividends just below or equal to a multiple of $0.125 (e.g., dividends between 10 cents and 121/2 cents) will exceed the return for those stocks paying cash dividends just above that multiple of $0.125 (e.g., dividends above 121/2 cents and below 15 cents). The results presented in Exhibits 2 and 3 of the paper confirm this. For example, on the days when NYSE stocks trade ex-cash dividend in an amount just below or equal to a multiple of $0.125, the average return is 0.212% above the market return. For ex-cash dividend amounts just above multiples of $0.125, the average

return is only 0.089% above the market return. For AMEX stocks, these figures are 0.326% (for dividends just below or equal to

multiples of $0.125) and 0.047% above the market return. Another prediction is that for small cash dividends below

$0.0625 per share, ex-day returns will be negative. This paper documents that for AMEX stocks that trade ex-cash dividend in an amount less than or equal to six cents per share, the average ex-day return is negative. The average NYSE return is positive, but very small.

Exhibit 5 of the paper shows that ex-stock dividend day returns for NYSE stocks exceed those for AMEX-listed stocks since the two exchanges adopted the rules for stock distributions. Ex-stock distribution day returns for AMEX stocks have declined since that exchange adopted the new rules for handling ex-day limit orders. Both of these results are consistent with the predicted effects of how the exchanges handle limit orders on ex-stock distribution days.

Thus, this paper presents considerable evidence that NYSE Rule 118 and AMEX Rule 132 influence ex-day abnormal returns. The magnitudes of the "distortions" are small, and given the level of transactions costs faced by most investors, it is

unlikely that the results have much practical importance, on

average. In the absence of transactions costs, however, the results have important implications for investors, portfolio managers practicing dividend capture strategies, and perhaps even corporations. Investors should not place market orders to buy stock on ex-dividend days; limit orders should be used instead. Those who

employ cash dividend capture strategies should target dividend amounts just below or equal to a multiple of $0.125 (at least for dividend amounts up to and including 50 cents per share). Cor-

porations might consider not paying quarterly dividend amounts

just above multiples of $0.125. Regulators should consider the effects of the exchange rules. In particular, because limit orders

provide competition for specialists, the rules lessen competition by effectively widening the spread of unfilled limit order prices. As a result, specialists have more monopoly power to affect prices on ex-days.

David A. Dubofsky



10 FINANCIAL MANAGEMENT / WINTER 1992

The Effects of Splitting on the Ex: A Microstructure Reconciliation

Our research investigates stock splits: why they happen, how they affect shareholder wealth, and whether they enhance liquidity for splitting firms. Prior research has not reached a clear-cut answer as to the role of stock splits. While there is definitely a favorable stock price reaction to the announcement of splits, the reason for the positive announcement return is not well-determined. Conventional wisdom suggests that the benefit of splits comes from improved share liquidity; yet empirical evidence has produced ambiguous results on liquidity. More detailed theoretical arguments pose stock splits as part of a strategy used by management to signal value, yet such arguments seem overly complex for such a basic management decision. Moreover, in spite of complex explanations, an anomaly remains: splitting firms also experience positive returns on the split execution day. This event is known well in advance, so any associated favorable information should already be priced into the stock.

We attack the issue of stock splits from several angles in an attempt to reduce the ambiguity of the prior studies. We center our analysis on NASDAQ firms because such firms are more

likely to desire liquidity enhancement than the cohort of larger firms that trade via the exchanges. We find that stock splits cause at least two things to happen. First, the dollar spread falls. Second, the average size of trades falls. We attempt to link these liquidity factors to other characteristics of stock splits.

As in the prior studies, we find that splitting firms experience positive stock price appreciation at the time of the split announcement. In addition, the split comes at the end of an extended run-up in equity value (over the preceding five years as well as the preceding two weeks) and appears to represent market verifica- tion of improvements in cash flows.

Like the earlier work, we also find positive price movements on the date of the execution of stock splits. But this latter price movement is actually rather different from the announcement day stock returns. There is little or no run-up in prices in the weeks and days prior to split execution, as the positive return occurs quite discretely on the ex-day. Consistent with this discreteness, the observed price behavior does not appear to reflect actual changes in equity value, but instead is related to order imbalances consequent to the execution.

We link these order imbalances to an inflow of new shareholders following split execution. Conventional wisdom is supported by the data. We find that firms use stock splits as a mechanism to

expand the shareholder base. The incoming orders that accom-

plish this function are necessarily one-sided, that is, buyers must outnumber sellers. New stockholders enter on the ask side of the

spread and cause a temporary, asymmetric increase in the bid-ask

spread of splitting firms. This movement in the spread shows up in stock prices as a positive return; yet these returns are illusory because an investor could not set up a trading rule that profited from a roundtrip transaction of buying at the ask and selling at the bid surrounding the execution of the split.

The new shareholders are predominately institutions. The number and fraction of institutional investors increases following stock splits. Indeed, the increase in institutional owners is directly related to the order imbalances around the ex-day and the illusory ex-day abnormal return. The increase in institutional investors tells us something about who is valuing the liquidity created by the splits. Since institutions can be assumed not to face the wealth constraints possibly borne by individual investors, it seems that

splits are not used to improve liquidity for prospective shareholders.

Instead, splits enable existing shareholders to sell off, in round lots, a portion of their ownership in the splitting firms. Individual shareholders desire to sell a portion of their holdings for diversification reasons related to the significant run-up experienced by their firms prior to the splits. Stock splits enable diversification

through a partial, rather than a complete, sell-off of shares. The results indicate that stock splits are a useful management

tool. For firms that have had the good fortune to rise in value, a

split can aid small shareholders by giving them a low-cost means to sell off some, but not all, of their holdings. While the split itself does not increase the size of the corporate pie, it does give old shareholders the flexibility to share their portion with new investors.

Michael T. Maloney and J. Harold Mulherin




AMEX-to-NYSE Transfers, Market Microstructure, and Shareholder Wealth

Each year some corporate managers decide to change the listing of their firm's common stock from the American Stock Exchange (AMEX) to the New York Stock Exchange (NYSE). In making this decision to switch auction markets, managers presumably act in the best interests of their shareholders. The potential implications of this managerial decision are far-reach- ing because differences between the AMEX and NYSE may affect security returns and share value. Little empirical research is available about whether shareholders benefit if a firm switches the trading location of its common stock from the AMEX to the NYSE.

In this study, we examine the market behavior of 72 common stocks moving from the AMEX to the NYSE from 1982 to 1989. Specifically, we try to answer two questions. First, what is the general pattern of market behavior around AMEX-to-NYSE transfers? This pattern is uncertain because economic explanations do not provide a compelling rationale for a specific pattern of returns based on differences between these two auction markets. Previous studies for firms switching from NASDAQ to the NYSE or AMEX show that stock prices rise before listing and fall afterward. Yet, the evidence differs on the impact of initial listing on shareholder wealth.

Second, does the pattern of market behavior around AMEX- to-NYSE transfers differ for stocks with low versus high transaction volume on the AMEX? We believe that the general pattern of returns over time is much greater for auction market switches of low versus high transaction volume stocks. Our reasoning is that low transaction volume AMEX stocks have more to gain by switching to the NYSE than their high volume counterparts. That is, stocks with low transaction volume while on the AMEX may experience greater visibility and market interest after switching to the NYSE than stocks with high transaction volume. Because of these information and liquidity effects, newly listed NYSE stocks, specifically those with low transaction volume while on the AMEX, may initially experience lower risk and higher returns.

Using standard event methodology, our evidence for the full sample shows that stock prices rise before the listing date but decline afterwards. One explanation for the pre-listing results centers on expectations of improved liquidity and signaling, but the rationale for the post-listing results remains puzzling. The evidence shows that the pre-listing gains do not offset the post- listing losses. We find strong evidence of a post-listing anomaly of significantly negative abnormal returns. For example, our

sample of AMEX-to-NYSE transfers has a cumulative abnormal return (CAR) of -7.5% for the 50 trading days after listing.

For the full sample, we also find that the market responds positively on the day the NYSE announces the listing application. The market does not show a significant response on the day the NYSE announces the approval of the listing application or on the listing date. This evidence suggests that the application announcement is the critical event date and, on average, the market responds positively to this event.

Dividing the AMEX stocks by transaction volume before NYSE listing gives notably different results from those reported for the full sample. The price increase before listing is greater and the subsequent price decline after listing is less for low volume compared with high volume stocks. For example, the CAR during the 50 trading days before listing is +7.4% for the low volume group but only +0.3% for the high volume group. For the 50 trading days after listing, the CARs of the low volume group are -4.9% for the low volume group versus -10.3% for the high volume group. Therefore, the value implications differ for AMEX-to-NYSE transfers with low versus high transaction volume. The significant underperformance of AMEX-to-NYSE transfers during the post-listing period holds mainly for stocks with high transaction volume while on the AMEX.

One economic explanation for the low volume stocks per- forming better than their high volume counterparts involves increased visibility and market interest after listing on the NYSE. If this notion is correct, the low volume group should experience a relatively greater increase in volume after switching to the NYSE than the high volume group. Our results using two volume measures support this belief. Also, the beta of the low volume group decreases after listing but the beta of the high volume group increases.

Our evidence suggests that managers of AMEX-listed firms should consider carefully the circumstances under which trans- ferring to the NYSE might yield favorable results. One implication of these results is that managers of AMEX firms whose stocks have high transaction volume should consider postponing listing on the NYSE if they are concerned about short-term price performance. However, the prospects for AMEX stocks with low transaction volume appear more favorable than for their high volume counterparts, at least in the short term.

H. Kent Baker and Richard B. Edelman




Explaining the NYSE Listing Choices of NASDAQ Firms

Traditionally, financial theory has offered little guidance to managers who must choose whether to list their stock on an

exchange or allow it to continue trading over-the-counter. Recent developments in market microstructure theory allow a more careful analysis of the exchange listing decision. Market microstructure theory implies that firms list their stocks on exchanges to reduce transaction costs to their investors. A major component of the cost of trading common stocks is the bid-ask spread. Several differences exist between the trading arrangements, or microstructure, of the New York Stock Exchange and NASDAQ that may contribute to differences in bid-ask spreads for a given stock depending on where it is traded.

At first glance, the NYSE is a monopoly dealer market and NASDAQ is a competitive dealer market. On the NYSE, only the

exchange-appointed specialist may make a market in a stock and each stock has only one specialist. Competition among NASDAQ market makers should reduce bid-ask spreads. However, the NYSE specialist faces competition from members of the public. Brokers representing the public can bypass the specialist and trade directly with each other at prices between the specialist's bid and ask quotes. Also, members of the public may place limit orders that supersede the specialist's quotes, thereby tightening the spread. Overall, the degree of effective competition in market

making may be as great on the NYSE as it is on NASDAQ. Stock exchange regulations require specialists to stabilize

prices more than unregulated dealers would, but NASDAQ market makers have minimal obligations. Price stabilization by NYSE specialists and the monitoring of specialists and trading by the exchange may induce firms to list.

In this article, we examine the characteristics of a large sample of firms that listed on the NYSE or qualified to list but voluntarily remained in the NASDAQ over-the-counter system. Small, thinly traded NASDAQ stocks with relatively few market makers should be most likely to benefit from the increased public inter- action and specialist stabilization on the New York Stock Ex-

change. Large, actively traded stocks with relatively many market makers are likely to have enough competitive quotes on

NASDAQ to minimize spreads. On the other hand, small stocks may receive little benefit from listing because specialists have incentives to concentrate their attention on the stocks that gener- ate the most trading volume.

The results show that firms that move tend to have smaller stock market capitalization, fewer shareholders, fewer market makers and lower share prices than NASDAQ firms in the same industry that could list but do not. Listing firms have larger relative volume per day, on average, than qualified nonlisting firms, but the dollar size of the average trade is smaller for listing firms. Firms with larger unexpected bid-ask spreads, after adjust- ment for the relationship in the broader NASDAQ market between spread and microstructure characteristics, are more likely to move. The results are consistent with the idea that firms list on the NYSE in search of a more liquid market for their stock.

Firms that move to the exchange tend to have been qualified to move for a shorter time than other firms in the same industry that could move but do not. We interpret the period of qualifica- tion as a measure of how much information is available about the firm. Listing firms are less likely than other qualified firms to have dual classes of traded common stock. Firms may choose not to list to avoid being forced to equalize voting rights across classes. Thus, the costs of an exchange listing, as well as the benefits, appear to be unequally distributed among qualified firms.

Our results support the idea that NASDAQ firms that qualify for a listing on the NYSE are not all equal in their ability to benefit from exchange listing. Managers of such firms should consider whether NASDAQ provides as liquid a market as can be expected given the size of the firm, the ownership structure, the share price level, the industry in which the firm operates, and other factors. If the answer is affirmative, it may be better to remain in the NASDAQ system. Listing on the NYSE will not automatically provide better liquidity.

Arnold R. Cowan, Richard B. Carter, Frederick H. Dark, and Ajai K. Singh




On the Management of Financial Guarantees

Financial guarantees, such as insurance against credit risk and contract default, serve an important function for virtually every player in the global economy - households, businesses, and

governments. Without such guarantees, both implicit and ex-

plicit, many economic activities would be less efficiently per- formed. This paper develops a framework for analyzing the efficient management of such guarantees in both the private and

public sectors. Our paper explores private-sector applications of guarantee

management in nonfinancial corporations as well as financial institutions. Just as there are special advantages to having government rather than private entities provide guarantees, so there are special problems. This paper identifies these advantages and

problems and explores some of the tradeoffs between government and private-sector solutions to the guarantee problem. A central

point is that the principles for effective management of guarantees are the same, whether in the corporate, financial or public sector.

Common situations discussed in which the analysis of guarantees is central to decision-making and management control by financial officers of nonfinancial firms are:

* Parent company guarantees of the debt or other contractual

obligations of a subsidiary.

* Swap and other derivative-security contracts entered into by the corporation.

* Pension obligations under defined-benefit pension plans. For financial intermediaries, the efficient management of

implicit and explicit guarantees is critical to business success. The customers of many types of financial intermediaries receive a promise of services in the future in return for payments to the firm now. Those promised future services are liabilities of the firm, both economically and in the accounting sense. There are

essentially three ways for an intermediary to provide assurances

against default risk to the customers who hold its liabilities:

* By having investors put in additional capital beyond that

required for funding of the physical investments and work-

ing capital needed to run the business.

* By purchasing guarantees of its customer liabilities from a private third party. This might be accomplished by a confederation of private parties as in the reinsurance market. This approach works best for covering customer liabilities where the risk is diversifiable, as in the case of mortality risk, or where the risk can be hedged in the capital markets, as in the case of stock market or interest rate risk.

* By government guarantees of its customer liabilities. This

approach may be best if the risk cannot be diversified or

hedged through the capital markets.

The three basic methods that a guarantor of liabilities has to

manage its business on a sound basis are:

* Monitoring. This method requires the guarantor to fre-

quently mark-to-market the assets and liabilities of the insured party and be ready and able to seize the collateral as soon as the party's net worth falls below a predeter- mined maintenance target.

* Asset Restrictions. This method of controlling costs re-

quires the insured party to (at least partially) hedge its

guaranteed liabilities and limits the volatility of its net worth.

* Risk-Based Premiums. Under this method, the guarantor charges a fee that is commensurate with the riskiness of the guarantee.

In practice, guarantors (whether private-sector or government) use combinations of all three methods. Depending on the context, some mixes will be more efficient than others.

When government serves as a guarantor, there are benefits but also often special problems. Governments are subject to constant

pressures from various interest groups to subsidize their activities. The provision of "cheap" government guarantees is a less "visible" form of subsidy than outright cash payments, price supports, or other forms that require either immediate cash out-

lays or budget allocations. If faced with a political constraint limiting the size of the

premiums that it can charge, the government can still adopt procedures using the other tools of management to maintain the

solvency of its guarantee activity, prevent excessive risk-taking, and avoid unintended subsidies. If it can, for instance, establish an effective system of monitoring, then premiums can be kept low with the system solvent. But, if it can neither charge adequate risk-based premiums nor monitor effectively, then the only route left open is asset restrictions. Reductions or increases in asset restrictions and monitoring of insured institutions should not be classified as acts of "deregulation" or "reregulation." All guarantors, whether government or private-sector providers, must apply some feasible combination of such controls to remain viable.

Robert C. Merton and Zvi Bodie




Sinking Fund Prepurchases and the Designation Option

The corporate borrower may, from time to time, choose to

purchase its outstanding bonds in the open market. Under SEC

regulations, the borrower may not resell these bonds, but must retire them in a manner governed by the relevant indenture.

When the only scheduled principal payment is at maturity, market purchases by the borrower have no effect on per bond value because the original cash flow pattern is not altered. In the

presence of a sinking fund requirement, however, these market

purchases do have an effect on bond values. The provisions of a typical sinking fund require that the

borrower retire fixed principal amounts at some fixed schedule of dates either by purchasing the bonds in the open market or by calling them, by lot, at par. Any open market purchases in excess of those required are called prepurchases.

Although it is not widely known, sinking fund indentures

normally allow borrowers to designate prepurchased bonds, at

any time, to any future sinking fund requirement. This designation option enables the borrower to alter the pattern of future cash flows. This paper discusses optimal designation policy and its effect on the value of outstanding bonds.

The prevalence of sinking fund provisions and of prepurchases supports the importance of this investigation. Of industrial bonds with original maturities longer than 10 years, about 51% have sinking fund provisions. Of those with original maturities longer than 20 years, about 77% have sinking fund provisions. Furthermore, about 66% of issuers of industrial sinking fund bonds have prepurchased more than one sinking fund payment. Over 30% of these issuers have prepurchased three or more

sinking fund payments. The option to designate prepurchased bonds is particularly

valuable when interest rates are significantly different from the

coupon rate. When interest rates are relatively low and bond prices are

above par, the borrower should choose to meet sinking fund

requirements by calling the required number of bonds at par. If, before exercising its call option, the borrower designates prepurchased bonds to later sinking fund dates, it lowers the amount

outstanding and raises the number of bonds called away from investors at par. In this way, designation can lower the value of

outstanding bonds.

On the other hand, designating bonds to satisfy future sinking fund payments sacrifices those future options to call bonds at par; without the obligation to retire principal on a particular date there is no right to call bonds at par on that date. Furthermore, due to interest rate movements, it may turn out that the sacrificed options were worth quite a bit, while the options on different sinking fund dates turned out to be worthless. In other words, ex post, it might have been better to designate the prepurchased bonds to a different set of sinking fund dates. An optimal designation policy weighs the benefits of raising the number of bonds called from investors against the sacrificed options and the loss of future designation flexibility.

When interest rates are relatively high and bond prices are below par, the borrower should satisfy its requirements through market purchases. But accumulators, by cornering the issue, may be able to force the borrower to pay inflated prices for its bonds. If the borrower has prepurchased some bonds, however, it could designate them to the current sinking fund requirement. In this way, the borrower postpones paying off the accumulators and lowers the value of their holdings. Thus, once again, the designation option enables the borrower to reduce the value of the remaining outstanding bonds.

Our paper presents an algorithm for deriving the optimal designation policy and for the valuation of sinking fund bonds in the presence of a designation option. The discussion encom-

passes other options commonly granted to the borrower, namely the American call option to repurchase the bond at declining strike prices and acceleration options to call multiples of the

sinking fund requirement, at par, on sinking fund dates. Numer- ical examples are then used to illustrate that bond prices will be lower if prepurchases have been higher. The magnitude of this effect is largest when interest rates are well below the coupon rate and when accumulators have cornered the issue at a time when interest rates are well above the coupon rate.

In summary, a borrower may be able to reduce the cost of

servicing sinking fund debt by adopting an active prepurchase policy and by optimally designating prepurchased bonds. Simi- larly, investors might profit from monitoring a borrower's prepurchase and designation policies.

Andrew Kalotay and Bruce Tuckman




Wealth Effects for Buyers and Sellers of the Same Divested Assets

There has been a major restructuring of corporate assets over the past decade in America. Some of the most notable restructur-

ing activity includes mergers of whole firms. However, much

restructuring involves the selling and/or buying of units, divisions, and selected assets of firms. These types of nonmerger restructuring of divisions and assets are called sell-offs and/or divestitures and are the focus of this study. Sell-offs typically occur to strategically realign the firms' assets and streamline

operations or to raise capital for firms in financial difficulty or close to financial distress. Moreover, the sales of divisions or divested assets are often made without competitive bids from more than one firm. Often the price of the transaction is not made

public at the announcement of the divestiture. There have been other studies that have measured the wealth impacts of divestitures on the buyers and sellers separately, but the purpose of this

paper is to measure the wealth effects of both the buyers and sellers of the same divested assets to determine how these wealth

gains are shared among buyers and sellers in a controlled sample of matched pairs.

Additionally, our analysis measures the wealth impacts of two

major factors that may affect how shareholders react to sell-off announcements. The first factor analyzed is the change in the financial condition of the selling firm. Firms in declining financial condition (i.e., decreases in expected cash flows) will find it more expensive to raise cash through the capital markets and may employ a sell-off to raise the needed cash. The divesting firm may lose negotiating power if a credit downgrade informs potential buyers of the seller's weakened financial condition. Our results indicate that downgraded divesting firms experience significantly lower share price increases than divesting firms that have not been

downgraded. Downgraded sellers experience average abnormal

price increases of 0.37% and nondowngraded sellers have aver-

age abnormal price increases of 1.13% at sell-off announcements. We also find that credit downgrades for sellers do not explain share price changes for firms that buy divested assets. The second factor analyzed is the failure to publicly disclose the transaction

prices paid for the divested assets. Stockholders' wealth re-

sponses to sell-off announcements will be conditioned on their

perception of whether a fair price was paid (received) for the divested assets. Our research finds that divesting firms experience greater share price increases if the transaction price is disclosed. Abnormal share price increases average 1.48% for sellers that disclose transaction prices and just 0.31% for sellers who do not disclose transaction prices. Moreover, we find that buying firms'

share price increases significantly only if the transaction price is disclosed.

Given that divesting-firm credit downgrades and transaction price disclosures influence share price changes at sell-off announcements, we examine the joint effect of these two factors on our matched set of buyers and sellers of the same divested assets. Downgraded sellers that do not disclose transaction prices should be met with the least favorable shareholder reaction at the announcements of sell-offs. This group is the only group of divesting firms in our sample that does not experience statistically significant share price increases (the average abnormal return is 0.13%) at sell-off announcements. Nondowngraded divesting firns that reveal the transaction prices average abnormal price increases of 1.89%. Firms buying divested assets from downgraded sellers and nondowngraded sellers experience significant share price increases only if the transaction prices are disclosed.

Our sample includes 278 matched pairs of buyers and sellers of the same divested assets. The sample period is 1981 to 1987. Seventy-seven divesting firms had credit downgrades prior to announcing the divestiture. The transaction prices were not disclosed at the announcement in 133 of the transactions in our sample. The average transaction price paid for the divested assets is $189 million. Downgraded sellers sold assets averaging $269 million and nondowngraded sellers sold assets averaging $155 million. However, the value of the divested assets relative to the value of the divesting firm's equity is smaller for downgraded sellers than for nondowngraded sellers. Buyers of divested assets average equity market values 7.38 times the equity market value of the divesting firms.

In summary, this paper measures the wealth impacts of sell- offs and the allocation of wealth between the buyers and sellers of the same divested assets. Several interesting findings are reported. Both buyers and sellers of the same divested assets gain wealth at announcement, on average. Buying firms gain the most wealth when the transaction price is disclosed. Sellers gain the most wealth when they have not been downgraded and when the price is disclosed. Thus, these results suggest that shareholders of divesting firms and shareholders of firms that acquire divested assets can both gain from restructuring. However, results from strategic sell-offs may differ from divestitures induced by im- pending financial distress. Also, the full disclosure of the terms of the transaction may play an important role in determining how shareholders will react to the news of restructuring.

Neil W. Sicherman and Richard H. Pettway



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