Internal Funds, Moral Hazard, and Post-Financing Stock Underperformance

This study investigates how external financing affects incentives and long-term post-financing stock performance conditioned on the availability of internal funds. Post-financing stock underperformance is concentrated among firms with low internal funds at the time of external financing, and is disproportionately large during earnings announcement periods. Furthermore, these firms experience less decrease in post-financing average selling, general, and administrative expenses due to economies of scale from expansion. Finally, related to their external financing activities, these firms have a weaker information environment represented by more optimistic analyst earnings forecasts, larger forecast dispersion, and lower analyst coverage. This empirical evidence is consistent with existence and underestimation of a moral hazard problem induced by conflicts between current shareholders and new claimholders when firms lack internal funds.