[15:47 30/10/2012 OEP-hhs112.tex] Page: 3645 3645–3683 Overvalued Equity and Financing Decisions

We test whether and how equity overvaluation affects corporate financing decisions using an ex ante misvaluation measure that filters firm scale and growth prospects from market price. We find that equity issuance and total financing increase with equity overvaluation, but only among overvalued stocks, and that equity issuance is more sensitive than debt issuance to misvaluation. Consistent with managers catering to maintain overvaluation and with investment-scale economy effects, the sensitivity of equity issuance and total financing to misvaluation is stronger among firms with potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover. (JEL G14, G32, M41) The inefficient markets approach to corporate finance predicts that a firm will raise more capital when it can obtain a higher price relative to fundamental value for the securities that it issues, and a relatively low price for the securities that it repurchases. By issuing more, the firm generates a profit for its existing shareholders, which, ceteris paribus, increases the long-term stock price. Furthermore, overoptimistic market valuations of investment opportunities can encourage firms to take actions to confirm such expectations (Polk an