The Effects of Covenant Violations on the Underpricing of Seasoned Equity Offerings and the Implied Cost of Equity Capital

Anh Ngo, Hong Duong () and Anthony Chen ()
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Anh Ngo: Department of Finance, Accounting, and MIS, School of Business, Norfolk State University, 700 Park Ave, Norfolk, VA 23504, USA
Hong Duong: Department of Accounting and Information Systems, College of Business Administration, The University of Texas at El Paso, 500 W University Ave, El Paso, TX 79968, USA
Anthony Chen: Department of Accounting, College of Business, Florida State University, 821 Academic Way, Tallahassee, FL 32306-1110, USA

Quarterly Journal of Finance (QJF), 2016, vol. 06, issue 01, 1-33

Abstract: This study examines the impact of covenant violations on the implied cost of equity capital and the underpricing of seasoned equity offerings (SEOs). Using a novel dataset of 1,028 first-time covenant violations from 1996–2011, we find a higher level of SEO underpricing during the period immediately following covenant violations. This suggests that creditors require violating firms to issue equity to lower leverage and that equity investors interpret the violation negatively. We also find that violating firms experience an average increase of 8.48% in the implied cost of equity capital. By comparing analysts’ earnings forecasts before and after the violations, we conclude that the negative effects on equity owe to the loss of flexibility that accompanies covenant violations, and are not simply a reflection of the deteriorating health of the firm.

Keywords: Covenant violations; seasoned equity offerings; underpricing; cost of capital (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1142/S2010139216400036

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