1. Market Timing and Capital Structure
Reading report
By 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 finance
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2. Market Timing and Capital Structure
sharp 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 finance
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