Equity market timing can be regarded as the practice to issue shares when their prices are high and to repurchase them when their prices are low. Exploiting the temporary fluctuation in the cost of equity is the main intention comparative to other forms of capitals’ costs. In the capital market that is efficient and integrated, there is not any independent variation in the cost of different forms of capital which leads to no gain from unscrupulously swapping between equity and debt. On the contrary, the capital marker that is segmented or inefficient, the ongoing shareholders are benefitted from market timing at the expense of the ones who are entering and exiting the market. It gives the managers incentive for timing the market in case they perceive it as possible and in case they care more about the ongoing shareholders. Therefore, timing the equity market seems to be a vital facet of the real corporate financial policies. In this paper, the authors try to get the answer of how capital structure is affected by the equity market timing. Therefore, the paper is trying to answer whether there is a short-run or long-run impact of market timing. This question is related to the hypothesis that capital structure is largely and persistently affected by market timing (Baker and Wurgler 2002).
Previous researches were involved in documenting the dependence of individual financial decisions on market-to-book. In this paper, the authors take an attempt to document the cumulative effect of the market-to-book ratios’ history on capital structure. The key questions that the authors are trying to answer include whether capital structure is affected by market-to-nook through net equity shares as implied by market timing, and whether the persistent effects of market-to-book are there that assists in explaining leverage’s cross section.
The main sample acquired by the authors consists of COMPUSTAT firms so that the IPO date can be determined. Information on the IPO date is useful to the authors as it permits them in testing the leverage’s behaviour around the IPO. Firms appearing at any time between 1968 and 1999 are considered for forming the main sample. The IPO dates are acquired from Jay Ritter and SDC. The whole sample consists of 2839 observations of the firms at the first financial year end after IPO, 2652 observations in the next financial year and 712 observations of the firms at the 10th financial year. In terms of the determinants of the annual changes in leverage, the authors document the market-to-book’s net effect on the annual leverage change. Then, the changes in leverage are documented so that it can be tested whether the effect comes through net issue of equity, as implied by market timing. Market-to-book is the main focus of the authors, but three other variables are also used for rounding out a benchmark set of control variables. Firm size, asset tangibility and profitability and the additional variables (Baker and Wurgler 2002).
In case of the determinants of leverage, it has been established by the authors that leverage is affected by market-to-book through net issue of equity in the short run. Whether or not it assists the authors in understanding the leverage’s cross section relies on perseverance. Therefore, leverage is regressed on the control variables along with another variable that summarize the market valuations’ relevant historical variation. Two main results have been documented by the authors. The first result states that leverage is reduced in the short run by high market valuation. The second result demonstrates that historically high market valuations have association with lower leverage in the cross section. The linkage between these two results indicates the high persistency of the effect of market-to-book. The empirical section is concluded by the authors by elaborating the extent and enormousness of this perseverance. It is demonstrated by the regression results that the weighted average market-to-book result is doubtful to reflect the characteristics of an omitted firm that would influence the early leverage. In its place, more evidence is provided by it that the capital structure is influenced by market valuations that perseveres and consequently gather over time (Baker and Wurgler 2002).
The authors have documented that market-to-book ratios’ fluctuations have substantial and permanent effects on leverage. The authors takes an honest attempt to explain the results by using the present theories assumed specific interpretations of the market-to-book ratio. The potential is also considered by the authors that capital structure advances as the past attempts’ consequence for timing the market. The authors opine that the results have more consistency with capital structure’s market timing theory.
As shown by Modigliani and Millar, capital structure has no relevance when the markets are perfect and efficient. An optimal capital structure is ascertained by the trade-off theory by accumulating different imperfections, such as costs of financial distress, taxes, and agency costs, but the assumptions of symmetric information and market efficiency are retained. One can connect the market-to-book ration to different elements of the trade-off theory. Firms with considerable growth and investment prospects have the most to miss when raising new capital is prevented by the overhanging debts. Therefore, the trade-off theory forecasts that the changes in the market-to-book ratio are ultimately attuned by capital structure. It is described in the pecking order theory that no optimal capital structure is there. The market-to-book ratio is regarded by this theory as a tool to measure the investment opportunities. Keeping this explanation in mind, it is noted that it is challenging to settle a concurrent relationship between capital structure and market-to-book ratio with the fixed pecking order model (Fama and French 2000). It is also suggested that high investment opportunity related periods will incline to drive leverage greater towards a volume of debt. However, it is suggested by the results that leverage is pushed towards lower debt capacity in these situations (Baker and Wurgler 2002).
In the vibrant theory of capital structure on the basis of managerial entrenchment theory, equity finance is eased by high valuation and good opportunities of investment, but all at once permits the manages to become entrenched (Zwiebel 1996). In order to rebalance in the later period, raising debt may then be refused by them. A market-timing essence is there in it as equity is issued by the managers when there is high valuation. The managers do not try to exploit new investors. Instead of that, the exiting investors are tried to be exploited by them by not rebalancing. The authors believe that the capital structure theory basis market timing is the most accepted elucidations of the results of this paper. Two types of equity markets are there. The first market is of dynamic form with rational investors and mangers, and the second market involves irrational investors and time-varying mispricing. Equity is issued by the managers when it is believed by them that the costs are unreasonably low, and thus, the equities are repurchased when the costs are unreasonably high. All these imply that an important aspect of the real financial decisions is the market timing, and the results of the paper seem to back this opinion (Jung et al. 1996).
In a capital market which is conventionally efficient and integrated, there is not any independent variation in the cost of different forms of finances as opportunistic switching does not provide any gain. In contrast, it is suggested by a variety of evidence that it is a crucial aspect to consider equity market timing for real financial policy. This paper involves tracing the implication to time the equity market through capital structure. The market-to-book ratio is used for measuring the market timing opportunities that the managers perceive. It is found that the lower leverage companies are those where funds are raised during high valuation, and contrariwise the firms with high leverage are those where funds are raised during low valuation. It is also found that market valuation related fluctuations largely influence the capital structure that continues for at least a decade. It is challenging to understand these results within traditional theories of capital structure. The authors believe that most accurate clarifications for the results is that capital structure is mainly the increasing result of the past attempts for timing the equity market. No optimal capital structure is there in this theory, consequently the market timing financing decisions just add into the capital structure outcome over the years. This modest capital structure’s market timing theory seems to have a considerable descriptive influence.
The main contribution of this paper can be seen in explaining and understanding the key aspects associated with market timing and capital structure. In addition, this paper is a crucial one for discussing the effect of market timing theory on the decisions regarding capital structure. The authors have contributed largely to undertake the necessary analysis to prove that a key aspect of real financing decisions is market timing. This paper also increases the importance of market timing theory to analyse capital structure because this is the only theory that can be used for providing the most natural explanation of the results and findings of the paper.
References
Baker, M. and Wurgler, J., 2002. Market timing and capital structure. The journal of finance, 57(1), pp.1-32.
Fama, E.F. and French, K.R., 2000. Testing Trade-off and Pecking Order Theory Predictions about Dividend and Debt. Working paper.
Jung, K., Kim, Y.C. and Stulz, R., 1996. Timing, investment opportunities, managerial discretion, and the security issue decision. Journal of Financial Economics, 42(2), pp.159-185.
Zwiebel, J., 1996. Dynamic capital structure under managerial entrenchment. The American economic review, pp.1197-1215.
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