1

Capital Structure: leverage dynamics and market timing

Advanced Corporate Finance

Semester 1 2009

2

Capital structure and financing choices

Two observations• Leverage is persistent – low/high leverage firms tend to

maintain that level

• Cross-sectional variation in leverage is characterized by an important firm specific effect• R2 from a regression of leverage on firm fixed effects is around

60%

Explanations offered:• Target capital structure (trade-off theory)

• No target optimum (pecking order, market timing or price inertia)

Explanations of capital structure choice: target capital structure

• Trade-off theory•Firms balance agency problems, tax

consequences, and distress costs to select a target capital structure that achieves the best overall value proposition for shareholders.

3

What target?

Book value or market value targets?• Survey data - Graham and Harvey (2001)

suggests that firms issue equity following stock price increases because CFOs believe that they can raise equity capital under more favorable terms in such situations.

• Book value - leverage ratios are likely to be strongly related to past stock returns - Welch (2004).• Kayhan and Titman (2006) - stock return effect does

partially reverse and does not subsume other determinates of capital structure

4

Explanations of capital structure choice: No target or optimum

Pecking-order theory• Firms use capital first from internal sources, and

then acquire external finance. Firms have more information than the market and it is difficult for them to get external (risky) finance. This could cause growth firms to keep low leverage levels to increase financial flexibility

5

Explanations of capital structure choice: No target or optimum II

Managerial entrenchment theory• Managers with good current prospects and

projects raise equity capital and keep leverage low to avoid debt discipline.

Market timing theory• BW argument that firms raise equity when prices

are high and buy-back equity when prices are low. So capital structure is more a consequence of cumulative past offerings based on share prices.

6

Market timing

Consider a firm who has a very high stock price, relative to fundamentals. In this environment it seems likely that the firm would consider raising new capital in the share market, i.e. selling new shares. Similarly, if the firm's share price is very low relative to fundamentals, then one would expect that the same firm would now repurchase its shares in the open market. This being the case it seems that a firm's capital structure would be a consequence of its share history, "that capital structure is the cumulative outcome of past attempts to time the equity market".

Rather than aligning with long-term targets, capital structures are a consequence of the market history.

7

Baker/Wurgler

In every year they compute the net changes in debt and equity. Net equity issues are computed by the change in book value of equity less retained earnings flowing to the balance sheet. Net debt issuance is computed in a similar way.• Alternatively, the financial deficit is defined as the sum of investments ,

dividends and changes in working capital, net of net cash flow. This sum is identical to net debt issues plus net equity issues .

Utilise external finance weighted average market to book ratio:• Sum of period s M/B ratio weighted by the proportion of period s financial

deficit to total financial deficit from the time of the firm’s IPO

Result: historical variation in market to book is more important than lagged market to book to understand current leverage and result is persistent

8

Issues

While stock price changes and financial deficits have strong influences on capital structure changes (Baker/Wurgler)

Effects are subsequently at least partially reversed (Kayhan and Titman, 2006)• Although a firm’s history strongly influence their

capital structures, that over time, financing choices tend to move firms towards target debt ratios.

9

Timing measure Event date measure

• Average measure issue timing Decomposing timing measure

• Yearly timing measure - covariance between FD and M/B – BW timing

• Long-term timing measure – intereacts average M/B and average FD• Tests whether managers act as though their costs of equity

financing is inversely related to the market-to-book ratio leading them to fund their financial deficit with equity rather than debt if their market-to-book ratio is sufficiently high

10

11