Wednesday, March 13, 2019
Market Timing and Capital Structure for Baker and Wurgler
It is well known that firms atomic image 18 more than credibly to issue rectitude when their commercialise values atomic number 18 superior, relative to decl are and ancient trade values, and to repurchase justice when their market values are humiliated. We document that the resulting burdens on capital structure are in truth persistent. As a consequence, current capital structure is strongly related to historical market values. The results evoke the possibleness that capital structure is the cumulative outcome of yesteryear attempts to period the justice market. Introduction Equity market timing refers to the practice of issuing shares at gritty prices and repurchasing shares at low prices.Equity market timing appears to be an important aspect of corporeal corporate financial policy. In this radical, B&W ask how equity market timing loads capital structure and whether it has a short-run or long-run impact. The interlingual rendition in market-to- deem ba lance is a procurator for managers perceptions of misevaluation. The main finding is that low supplement firms are those that raised funds when their market valuations were high (measured by the book-to-market ratio), musical composition high supplement firms are those that raised funds when their market valuations were low.The influence of past market valuations in capital structure is economically signifi undersurfacet and statistically robust. The influence of past market valuations on capital structure is withal quite persistent, this means that they meet a long-run impact. The tradeoff guess predicts that temporary fluctuations in the market-to-book ratio or any other protean should have temporary cause. The evidence however tapers long-term effects as well. The standard pecking- parade opening implies that periods of high investment allow for push leverage higher toward a debt capacity, not lower as the results in this paper suggest.The theory of entrenched manager s suggests that managers exploit existing investors ex post by not rebalancing the capital structure with debt, this may be an explanation of the findings in this paper. 1. Capital structure and past market valuations Individual financing decisions depend on market-to-book ratios. Does market-to-book affects capital structure through last(a) equity issues as market timing implies? And does market-to-book has persistent effects that help to explain the fall guy section of leverage? Data and summary statistics.Table I shows that book leverage decreases perspicaciously following the IPO. Over the next 10 years, it rises slightly, while market value leverage rises more strongly. The book leverage leaning is an age effect, not a survival effect. Most notable is the sharp switch to debt finance in the year following in the IPO. under B&Ws definitions for financing activity, the change in assets is tally to the sum of net debt issues, net equity issues, and newly retained winnings. The cooccurring increase in equity issues is suggestive of market timing.Determinants of annual changes in leverage B&W document the net effect of market-to-book on the annual change in leverage. Then they decompose the change in leverage to examine whether the effects comes through net equity issues, as market timing implies. Three control varyings are used that have been found to be correlated to leverage Asset tangibility, profitability, and firm size. B&W regress each component (equity issues, debt issues, and newly retained earnings) of changes in leverage on the market-to-book ratio and other independent variables.This allows them to determine whether market-to-book affects leverage through net equity issues, as market timing implies. The effect of market-to-book on changes in leverage does indeed come through equity issues. Panel C shows that market-to-book is not strongly related to retained earnings, impression out the possibility that market-to-book affects leverage be cause it forecasts earnings. The effect of profitability on changes in leverage arises primarily because of retained earnings. Firm size plays an important role at the time of the IPO. Determinants of leverage.If managers do not rebalance to some target leverage ratio, market timing may have persistent effects, and historical valuations will help to explain why leverage ratios differ. The relevant historical variation in market valuations is measured by the international finance weighted-average market-to-book ratio. This variable takes high values for firms that raised external finance when the market-to-book ratio was high and vice-versa. The intuitive motivation for this weighting scheme is that external financing events follow practical opportunities to change leverage.It therefore gives more weight to valuations that prevailed when significant external financing decisions were being made, whether those decisions ultimately went toward debt or equity. This weighted average is kick downstairs than a set of lagged market-to-book ratios because it picks out, for each firm, precisely which lags (intervals) are likely to be the or so relevant. Intuitively the weights correspond to times when capital structure was most likely to be changed. When firms go public, their capital structure reflects a number of factors, including market-to-book, asset tangibility, size, and research and development intensity.As firms age, the cross-section of leverage is more and more explained by past financing opportunities, as determined by the market-to-book ratio, and past opportunities to accumulate retained earnings, as determined by profitability. diachronic within-firm variation in market-to-book, not current cross-firm variation, is more important in explaining the cross section of leverage. The results from Table III and IV show that the effect of historical valuations on leverage is rotund and separate from confused effects documented in prior literature.Persisten ce So far 2 main results have been documented. First, high market valuations reduce leverage in the short run. Second, historically high market valuations are associated with lower leverage in the cross section. By measuring changes from the leverage prevailing in the year before the IPO, the dependent variable includes the effect of the IPO itself. This is multipurpose because the IPO is a critical financing event known to be connected to market value. Historical market valuations have large and very persistent effects on capital structure.This effect is independent of various control variables. 2. Discussion Tradeoff theory In perfect and effectual markets capital structure is irrelevant. Some of the imperfections that lead to an optimal tradeoff are as follows Higher tax revenuees on dividends indicate more debt, higher non-debt tax shields indicate little debt, higher cost of financial distress indicate more equity, agency problems can call for more or less debt. The market -to-book ratio can be connected to several elements of the tradeoff theory entirely it is most commonly attached to costly financial distress.The mark testable prediction of the tradeoff theory is that capital structure eventually adjusts to changes in the market-to-book ratio. However, evidence indicated that variation in the market-to-book ratio has a decades-long impact on capital structure. B&Ws results make the point that a considerable fraction of cross-sectional variation in leverage has cipher to do with an optimal leverage ratio. Pecking order theory In the pecking order theory there is no optimal capital structure. The static position predicts that managers will follow a pecking-order (internal, debt, equity).The pecking order theory regards the market-to-book ratio as a measure of investment opportunities. Periods of high investment opportunities will black market to push leverage higher toward a debt capacity. However, to the extent that high past market-to-book re ally coincides with high past investments, B&Ws results suggest that such periods tend to push leverage lower. The dynamic version predicts a relationship between leverage and future investment opportunities. B&Ws results control for current market-to-book and show that leverage is much more strongly determined by past values of market-to-book.Managerial entrenchment theory High valuations and good investment opportunities facilitate equity finance, but at the same time allow managers to become entrenched. They may consequently refuse to raise debt to rebalance in later periods. Market timing theory Capital structure evolves as the cumulative outcome of past attempts to time the equity market. There are two versions of equity market timing. The root is a dynamic form with rational managers and investors and adverse selection costs that vary across firms or across time.Temporary fluctuations in the market-to-book ratio measure variations in adverse selection (information asymmetry) . The second version of equity market timing involves irrational investors or managers and time-varying mispricing. If managers try to exploit too-extreme expectations, net equity issues will be positively related to market-to-book. The critical presumption is that markets need not be inefficient, managers may simply believe that they can time the market. 3. Conclusion A variety of evidence suggests that equity market timing is an important aspect of real financial policy.This evidence comes from analyses of actual financing decisions, analyses of long-run returns following equity issues and repurchases, analyses of realized and forecast earnings around equity issues, and surveys of managers. We find that fluctuations in market valuations have large effects on capital structure that persist for at to the lowest degree a decade. The most realistic explanation for the results is that capital structure is for the most part the cumulative outcome of past attempts to time the equity m arket.