Ronald Masulis42 has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities.

Masulis found that debt for equity exchanges were good news (stock price increased on announcement) and equity for debt exchanges were bad news.

(a) Are these results consistent with the trade-off theory of capital structure?

(b) Are the results consistent with the evidence that investors regard announcements of (i) stock issues as bad news, (ii) stock repurchases as good news, and (iii) debt issues as no news, or at most trifling disappointments?

(c) How could Masulis’s results be explained?