Market Timing and Capital Structure

Reading reportBy Babacar SECK

Market Timing and Capital Structure

MALCOLM BAKER and JEFFREY WURGLER

Quote “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful”. Warren Buffett 1

The “equity market timing» aims to take advantage to temporary fluctuations in the cost of

equity relative to the cost of other forms of capital. This practice is useful for ongoing

shareholders at the expense of entering and exiting ones in ineficient and segmented capital

market in the sense of Modigliani Miller theorem. Indeed, we find evidence in many prior

studies to the importance of market timing in real corporate financial policy.

The authors try to understand in what extent equity market timing affects capital structure by

analyzing its impact on the time horizon (whether market timinig has a long run or short run

impact).

The authors try to understand in what extent market-to-book affects capital structure through

net equity issues, consistent to market timing and the magnitude of its effetcs to the

explanation of the cross section of leverage.

Therefore, they use a sample of COMPUSTAT2 firms that went public between 1968 and

1998, in order to examine the behavior of leverage around the IPO because of its important

relation to the market-to-book ratio and finally to study the evolution of leverage from a fixed

starting point.

Consistent with the expectations data analysis in years relative to the IPO for firms

with a known IPO date shows that, following the IPO, book leverage plummets and the bear

rythm becomes slower compared to early periods, while at the same time market value

leverage rises more strongly. However regarding the financing activity, the main finding is the

1 One of the quotes that have earned Warren Buffett the nickname the "Oracle of Omaha."2

Compustat is a market database published by Standard and Poor's. The comprehensive Compustat database provides company data going back 40 to 50 years on over 65,000 securities, as of 2010. The type of information published by Compustat include: Global Industry Classification Standards (GICS), pricing data, earnings data, insider and institutional holdings, and other information directed at investors and analysts. Cf. Investopedia.com

Journal of finance1

Market Timing and Capital Structuresharp switch to debt finance in the year following the IPO. This fact causes a significant

change by establishing a steady pattern in average in financing activity.

In addition, the analysis of data in calendar time for all COMPUSTAT firms shows a decrease

in market leverage, and in internal finance but an increase in equity issues.

In the same vein, the analysis of determinants of annual changes in book leverage confirms

the idea that firms increase equity when market valuations are high. In fact, the results show

at IPO + 3 (subsample that hold 3 years since the IPO), that a one standard deviation increase

in market-to-book is associated with a 1.14 percentage-point decrease in le-verage. In

addition, tangible assets tend to increase leverage, profitability tends to reduce leverage and

size tends to increase leverage. Therefore those results confirm conclusions of prior studies.

Furthermore, by the manner of which the change in leverage comes about: we find firstable as

expected that, higher market-to-book is associated with higher net equity issues. Another

interesting result is that market-to-book is not strongly related to retained earnings. Finally, if

we a make glance to the analysis of change in book leverage due to growth in assets we can

note that market-to-book is positively related to growth in assets, an effect that tends to

increase leverage. Therefore the main idea of all those results is that market-to-book affects

leverage through net equity issues.

Moreover, in terms of asset tangibility, profit-ability, and size, they find firstable that

Profitable firms issue less equity, but this effect is more than offset by higher retained

earnings. Then the fact firm size has a significant impact in terms of the timing of going on

public. Therefore, they find that, the reduction in leverage that occurs at the IPO is much

smaller for large firms. And the fact that large firms issue less equity as a percentage of assets.

They also find that fluctuations in market value have very long-run impacts on capital

structure. But, understanding these results are very complicated within traditional theories of

capital structure such as the Pecking Order Theory.

As far as concerned the authors, a simple and realistic explanation for the results is that capital

structure is the cumulative outcome of attempts to time the equity market. Therefore

consistent to this idea, there is no optimal capital structure

Journal of finance2