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Market Timing and Capital Structure Evidence from Hong Kong Listed Companies

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Faye Wang
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      Market  Timing  and  Capital  Structure:   Evidence  from  Hong  Kong  Listed  Companies     Submitted  by  Feifei  Wang  to  the  University  of  Exeter     as  a  dissertation  towards  the  degree  of  Master  of  Science  (MSc)   in  Financial  Analysis  and  Fund  Management     August  2016     Supervisor:  Dr  Pedro  Angel  Garcia  Ares     I  certify  that  all  material  in  this  dissertation  which  is  not  my  own  work  has  been  identified  and   that  no  material  is  included  for  which  a  degree  has  previously  been  conferred  upon  me     Signature…………………………………………………………....      
2 Abstract       Capital  structure  is  always  a  keyword  associated  with  modern  corporate  finance.  Market   timing  theory  is  a  popular  strand  among  theories  about  capital  structure.  This  dissertation   uses  IPO  data  from  227  Hong  Kong  listed  companies  from  2005  to  2015.  I  hope  to  provide   a  refreshing  view,  as  little  prior  research  focuses  on  the  Hong  Kong  market,  and  the   majority  of  past  literature  apply  data  available  no  later  than  2003.  The  main  methodology   is  linear  regression  and  I  apply  three  different  models  to  test  the  existence  of  short-­term   and  long-­term  effects  of  market  timing  respectively.  The  results  confirm  that  1)  market   timing  actions  exist  in  both  in  debt  financing  and  equity  financing  decisions  of  Hong  Kong   listed  companies  2)  short-­term  effects  of  market  timing  on  capital  structure  exist  and  3)   persistent  effects  of  market  timing  behaviour  on  capital  structure  that  can  last  for  10  years   exist.  This  dissertation  provides  evidence  to  support  the  market  timing  theory  in  Hong   Kong   listed   companies.   The   result   is   consistent   with   the   majority   of   studies   based   in   developed  economies.      
3 TABLE  OF  CONTENTS   ACKNOWLEDGEMENTS  .............................................................................................................  5   1.  INTRODUCTION  .......................................................................................................................  6   1.1  PROBLEM  DEFINITION  ...........................................................................................................  6   1.2  OBJECTIVE  STATEMENT  ........................................................................................................  8   1.3  STRUCTURE  OF  THIS  DISSERTATION  ......................................................................................  8   2.  LITERATURE  REVIEW  ............................................................................................................  9   2.1  TRADE-­OFF  THEORY  ..............................................................................................................  9   2.1.1  Static  trade-­off  theory  ...................................................................................................  9   2.1.2  Dynamic  trade-­off  theory  ............................................................................................  10   2.2  PECKING  ORDER  THEORY  ....................................................................................................  11   2.3  THEORY  BASED  ON  AGENCY  COSTS  .....................................................................................  11   2.3.1  Managerial  entrenchment  theory  ...............................................................................  12   2.4  MARKET  TIMING  THEORY  .....................................................................................................  13   2.4.1  Windows  of  opportunity  hypothesis  ............................................................................  13   2.4.2  Perceived  mispricing  ..................................................................................................  14   2.4.3  Adverse  selection  .......................................................................................................  15   3.  METHODOLOGY  ....................................................................................................................  18   3.1  VARIABLE  DEFINITION  .........................................................................................................  18   3.1.1  Market  timing  indicator  ...............................................................................................  18   3.1.2  Capital  structure  and  determinants  ............................................................................  20   3.2  HYPOTHESIS  AND  MODELS  ..................................................................................................  23   3.2.1  Hypothesis  1  Existence  of  Market  timing  ...................................................................  24   3.2.2  Hypothesis  2:  Short-­term  effect  ..................................................................................  25   3.2.3  Hypothesis  3:  Persistent  effect  ...................................................................................  26   4.  DATA  ......................................................................................................................................  28   5.  RESULTS  AND  ANALYSIS  ....................................................................................................  30   5.1  EXISTENCE  OF  MARKET  TIMING  BEHAVIOUR  ..........................................................................  30   5.2  SHORT-­TERM  EFFECTS  OF  MARKET  TIMING  BEHAVIOUR  ........................................................  34   5.3  PERSISTENT  EFFECT  OF  MARKET  TIMING  BEHAVIOUR  ............................................................  36   6.  CONCLUSION  ........................................................................................................................  39   6.1  LIMITATIONS  .......................................................................................................................  39   6.2  SUMMARY  ...........................................................................................................................  40   APPENDICES  .............................................................................................................................  41   REFERENCES  ............................................................................................................................  43    
4 LIST  OF  TABLES   Table  1  Various  Equity  Choices  under  “Windows  of  Opportunity”  ……………..………..14   Table  2  Summary  of  Capital  Structure  Theories…………………………………………...17   Table  3  Summary  of  Different  Choices  on  Market-­timing  Indicators……………..………19   Table  4  Summary  of  Variable  Definitions   ………………………………………………..23   Table  5  Summarised  Statistics  of  Capital  Structure  and  Financing  Decisions.………...30   Table  6  Pearson  Correlation  between  Variables…………………………………………...32   Table  7  Coefficients  of  Model  1a  ...………………………………………………………….33   Table  8  Coefficients  of  Model  1b&1c  ...……………………………………………………..33   Table  9  Coefficients  of  Model  2a  …………………………………………………………....34   Table  10  Coefficients  of  Model  2b…………………………………………………………...35   Table  11  Coefficients  of  Model  3a…………………………………………………………...36   Table  12  Summary  of  Subsamples  Coefficients  …………………………………………..37      
5 Acknowledgements     I  would  like  to  express  sincere  appreciation  to  my  supervisor  Dr  Pedro  Angel  Garcia  Ares   for  his  constant  guidance  and  support.  He  always  encouraged  me  to  explore  the  field  I   was  interested  in  and  provided  thorough  advice  on  my  work.  His  suggestions  helped  me   understand  how  to  conduct  and  organise  a  professional  dissertation  and  help  me  get  to   where  I  am  today.   I  would  like  to  convey  my  heartfelt  thanks  to  Dr  Angela  Christidis,  who  is  the  module   coordinator  for  finance  dissertation,  for  her  help  to  me  and  her  efforts  to  this  dissertation.   I  would  also  like  to  present  my  honest  gratitude  to  Eugene  for  all  the  inspirations  from   those  interesting  discussions  with  you.  I  don’t  know  where  I’d  be  without  you.   Last,  but  definitely  not  the  least,  I  would  like  to  thank  my  parents  and  my  whole  family,  for   accompanying  me  through  tough  days  with  your  encouragement  and  belief  in  me.  I  will   always  remember  your  eternal  love,  in  those  times  when  I  need  them  the  most.      
6 1.  Introduction     Capital  structure  must  not  be  a  strange  word  to  most  of  people  as  it  is  vital  to  corporate   finance.  After  Modigliani  and  Miller  published  their  study  about  capital  structure  in  1958,   it  has  become  a  popular  topic  and  many  researchers  have  made  their  contribution  to  the   field.  In  general,  capital  structure  is  a  mix  of  sources  for  firms  to  raise  capital,  and  normally   it  is  comprised  of  debt  and  equity.  Firms  make  so  much  effort  to  allocate  debt  and  equity   in  an  appropriate  way  in  order  to  maximise  firm  value  and  shareholder  interest.   There  are  mainly  two  traditional  theories  about  capital  structure:  One  is  trade-­off  theory,   and  the  other  is  pecking  order  theory.  These  two  theories  form  the  fundamentals  for  other   theories.  However,  traditional  trade-­off  theory  assumes  the  existence  of  an  optimal  capital   structure,  and  pecking  order  theory  requires  an  absolute  order  of  financing.  Thus,  both  of   them  do  not  seem  to  fit  the  flexible  financial  environment  that  exists  nowadays.  This  is   what   makes   the   appearance   of   the   “market   timing”   concept   so   important.   It   was   first   introduced  in  Baker  &  Wurgler  (2002),  where  they  describe  the  theory  as  “capital  structure   is  the  cumulative  outcome  of  attempts  to  time  the  equity  market”.  Market  timing  theory   absorbs   concepts   from   previous   theories   and   develops   upon   them,   but   it   does   not   necessarily   need   any   assumptions,   unlike   trade-­off   theory   or   pecking   order   theory.   It   adapts  to  the  new  pattern  of  corporate  finance  where  firms  pay  more  attention  to  market   situations  than  previous  years  when  they  are  making  financial  decisions,  which  makes   the  new  theory  valuable  and  worth  studying.     1.1     Problem  Definition     Whether   market   timing   behaviour   exists;;   whether   it   will   bring   significant   influence   to   capital  structure;;  does  the  effect  exist  in  the  short  or  long  run  time  horizons,  and  does  it   only  apply  to  developed  markets?  Many  questions  remain  unanswered.   The  first  controversial  issue  is  whether  the  market  timing  behaviour  examined  in  the  study   of  Baker  &  Wurgler  (2002)  really  exists.  In  their  paper,  market  timing  is  a  behaviour  in   which  firms  adopt  different  actions  according  to  market  situations  when  making  financing   decisions.  To  be  more  specific,  firms  issue  equity  when  they  think  the  market  is  booming,  
7 and  thus  their  stocks  tend  to  be  overvalued.  In  contrast,  firms  will  repurchase  those  stocks   when  the  market  is  relatively  depressed.  Hence,  in  Model  1  of  this  dissertation,  equity   financing  and  debt  financing  are  applied  as  two  dependent  variables,  the  market  to  book   value  is  the  independent  variable,  and  this  paper  aims  to  test  the  relationship  between   them.  If  the  market  timing  theory  holds,  there  should  be  an  inverse  relationship  between   market  to  book  value  and  debt,  while  a  positive  relationship  between  that  and  equity   issued.  Results  from  Model  1  confirm  both  debt  timing  and  equity  timing  of  Hong  Kong   listed  companies.   Aside  from  the  question  on  the  theory’s  existence,  another  problem  is  the  geographical   application  of  this  theory.  Since  the  study  of  Baker  &  Wurgler  (2002),  their  empirical  study   has   attracted   much   attention   as   plenty   of   scholars   have   devoted   themselves   into   the   investigation  of  the  new  theory.  Abundant  studies  have  proven  the  existence  and  effects   of  market  timing  behaviour  in  different  markets,  the  majority  of  which  use  information  from   American  listed  companies  and  their  IPOs.  Xu  (2009)  made  investigations  of  Canadian   companies  and  proves  the  influence  of  historical  IPOs  on  capital  structure.  Sautner  and   Spranger  (2009)  present  the  result  of  European  listed  companies  and  support  this  theory,   while  Hermanns  (2006)  supported  this  theory  by  result  of  an  empirical  study  in  Germany.   However,  the  relationship  seems  to  apply  only  for  firms  in  developed  markets.  Zhou  (2011)   made  a  thorough  study  in  China,  but  failed  to  prove  the  effects  both  in  the  short,  and  long,   runs.   Whether   market   timing   theory   only   applies   to   developed   markets   has   become   another  source  of  intrigue  to  researchers.     Finally,  many  researchers  are  also  concerned  about  whether  the  effect  of  market  timing   behaviour  lasts  in  the  short  run  or  long  run.  Baker  &  Wurgler  (2002)  shows  a  significant   short-­term  influence  and  a  persistent  effect  that  can  last  for  about  10  years.  Therefore,   this  dissertation  designs  Model  2  and  Model  3  to  test  the  short-­term  and  persistent  effects   respectively.  Model  2  uses  data  of  both  current  period  and  the  last  period  to  assess  the   consequence  of  periodical  change.  Model  3  introduces  the  variable  of  the  external  finance   weighted-­average  market-­to-­book  ratio  that  was  created  by  Baker  &  Wurgler  (2002)  to   represent  the  accumulated  historical  market  timing  behaviour  to  evaluate  their  effect  in   the  long  run.  
8 1.2  Objective  Statement     Briefly  speaking,  this  dissertation  aims  to  answer  3  questions  that  correspond  to  those  in   the  Problem  Statement  above:  1)  Whether  market  timing  behaviour  exists  in  Hong  Kong   listed  companies;;  2)  Whether  the  short-­term  effect  of  market  timing  behaviour  to  capital   structure  exists  in  Hong  Kong  listed  companies;;  and  3)  Whether  a  persistent  effect  exists   in  Hong  Kong  listed  companies.     As  mentioned  before,  researchers  have  found  evidence  in  different  developed  markets,   but  few  scholars  have  conducted  research  in  the  Hong  Kong  area.  Yiu  (2016)  reported  in   the  South  China  Morning  Post  that  Hong  Kong  has  surpassed  New  York  to  become  the   top  IPO  market  in  the  world.  Equity  market  timing  is  a  vital  element  in  IPO  issue,  thus  it   is  worth  studying  the  Hong  Kong  market.  Hong  Kong  is  a  developed  market  in  Asia,  but   its  special  relationship  with  mainland  China  makes  the  market  unique.  Many  studies  failed   to  find  evidence  on  effects  of  market  timing  in  China  market  as  it  is  an  emerging  market.   Whether  the  close  relationship  between  the  Hong  Kong  market  and  China  market  affects   the   result   is   one   of   the   questions   that   need   clarification.   In   addition,   the   majority   of   literature  referred  in  this  dissertation  apply  data  available  no  later  than  2003.  This  paper   uses  data  ranging  from  2005  to  2015,  which  is  quite  an  updated  period.  Thus,  one  of  my   objectives  is  to  test  whether  the  theory  still  stands  in  the  new  era  of  corporate  finance.   1.3     Structure  of  this  Dissertation     There  are  5  parts  to  this  dissertation:  1)  Introduction,  providing  background  information,   giving   the   problem   definition   and   expressing   the   objectives   of   this   dissertation   2)   Literature  Review,  providing  summary  of  related  literature,  classified  theories  into  various   categories   and   explaining   relationships   between   different   theories   3)   Methodology,   demonstrating  statistical  methods,  hypotheses  and  models.  Additionally,  it  also  contains   a   data   description   and   variable   definition   4)   Result   and   Analysis,   illustrating   detailed   results  with  various  tables,  and  presenting  thorough  analyses  of  results  5)  Conclusion,   outlining   limitations   and   summarising   this   dissertation.   The   remaining   parts   are   the   Abstract  at  the  beginning,  APA  style  references  and  an  Appendix  at  the  end.    
9 2.  Literature  review     I  introduce  various  theories  about  capital  structure  in  this  part  to  compare  reasons  behind   different   choices   for   different   companies.   The   objective   of   this   paper   is   to   study   the   relationship  between  capital  structure  and  market  timing  strategies,  and  therefore  the   market  timing  theory  is  emphasised  here.  The  publication  of  Modigliani  and  Miller  in  1958   can   be   considered   as   the   beginning   of   studies   on   capital   structure.   According   to   the   Modigliani-­Miller  theorem  (MM,  1958),  under  the  premise  of  efficient  markets  (that  the   market  is  free  of  arbitrage)  and  excluding  tax  issues,  bankruptcy  cost  and  asymmetric   information,  firm  value  is  not  related  with  the  amount  of  leverage,  or  how  the  company   raises   capital.   After   that,   the   amount   of   studies   and   literatures   increases   rapidly   and   several  strands  of  theories  are  formed.   2.1  Trade-­off  theory     The   most   important   assumption   of   the   Modigliani-­Miller   theorem   is   there   is   no   tax.   However,  for  modern  corporations,  this  assumption  cannot  stand  and  debt  seems  more   like  an  efficient  way  of  raising  capital,  because  the  interest  on  debt  may  be  tax  deductible.   Trade-­off  theory  developed  on  the  base  of  the  Modigliani-­Miller  theorem  in  1958  and  its   core  argument  is  that  capital  structure  has  influence  on  firm  value,  and  an  optimal  capital   structure  exists.  Theories  can  be  classified  into  two  categories:  “Static”  and  “Dynamic”.   2.1.1  Static  trade-­off  theory     Static  trade-­off  theory  can  be  viewed  as  an  improved  version  of  the  MM  model.  In  sum,   the  static  trade-­off  theory  takes  the  effects  of  both  taxation  and  bankruptcy  costs  into   account,  and  confirms  the  presence  of  the  optimal  capital  structure.   Firstly,   tax   issues   have   been   taken   into   consideration.   In   1963,   Modigliani   and   Miller   introduced  corporate  income  tax  into  the  original  MM  model.  According  to  Miller  (1977),   both  change  in  individual  income  tax  and  change  in  corporate  income  tax  have  influence   on  the  optimal  capital  structure.  To  be  more  specific,  facing  higher  corporate  income  tax   rates,  firms  will  prefer  acquiring  capital  from  debt  rather  than  issuing  equities,  due  to  the  
10 tax  shield.  Under  higher  individual  income  tax  rates,  and  when  the  tax  rate  of  dividend   income  is  lower  than  that  of  interests  of  issuing  debt,  firms  will  choose  to  raise  capital  by   issuing   shares.   Secondly,   the   bankruptcy   cost   is   incorporated   into   the   MM   model.   Modigliani  and  Miller  (1963)  drew  a  conclusion,  that  there  is  a  growth  in  firm  value  as  a   result  of  increased  debt-­to-­asset  ratios,  and  therefore  the  optimal  capital  structure  should   be   100%   liabilities.   However,   in   the   event   of   heavy   debt,   the   possibility   of   a   firm’s   bankruptcy  will  increase  significantly.  Once  bankruptcy  happens,  various  expenses  will   follow.   Hence,   firm   should   realise   that   though   debt   brings   a   firm   benefit   from   tax   deductions,   it   also   delivers   risks   of   collapse.   Figure   1   in   appendices   provides   the   illustration  of  the  static  trade-­off  theory.   2.1.2  Dynamic  trade-­off  theory     Dynamic  trade-­off  theory  holds  the  assumption  of  semi-­strong  market  efficiency,  and  that   managers  make  financing  decision  for  the  maximisation  of  firm  value.  Compared  to  the   static   theory,   the   dynamic   version   further   illustrates   the   relationship   between   capital   structure  and  different  costs  during  a  firm’s  process  of  adjustment.     Stiglitz  (1973)  was  the  pioneer  of  the  dynamic  trade-­off  theory.  He  built  the  fundamentals   of  this  theory  based  on  the  tax  shield  benefit  and  bankruptcy  cost.  Myers  (1984)  proposed   the  idea  in  static  trade-­off  theory  that  a  firm  will  set  a  goal  of  optimizing  capital  structure,   and  thought  the  dynamic  trade-­off  theory  is  about  how  firms  adapt  their  capital  structure   towards  the  targeted  one  step  by  step  after  events.  Fischer,  Heinkel  and  Zechner  (1989)   introduced   the   concept   of   adjustment   cost   into   the   theory.   If   adjustment   cost   is   acknowledged,  there  will  always  be  differences  between  the  actual  capital  structure  and   the  optimal  one  that  a  firm  wants  to  reach,  and  the  speed  of  adaptation  is  determined  by   the  cost  of  alteration.  The  presence  of  adjustment  cost  constraining  a  company’s  capital   structure  fluctuates  within  a  certain  range,  and  only  when  the  gap  between  actual  capital   structure  and  the  target  one  is  relatively  large,  will  the  firm  make  adjustments  to  their   capital  structure.  
11 2.2  Pecking  order  theory     Compared  to  trade-­off  theory,  the  pecking  order  theory  does  not  necessarily  require  the   existence   of   an   optimal   capital   structure   and   it   believes   financial   leverage   is   an   accumulated  result  of  historical  capital  raising  activities.   The  pecking  order  theory  was  first  proposed  by  Myers  (1984).  The  theory  illustrates  the   priority   of   methods   in   raising   funds   under   the   effects   of   adverse   selection   due   to   information  asymmetry.  Given  several  ways  a  firm  can  choose  to  finance  its  activities,   firms  tend  to  pick  internal  financing  as  their  first  choice,  followed  by  debt  financing,  and   equity  financing  will  be  the  last  resort.  Myers  (1984)  stated  that  if  the  firm  accumulates   enough  retained  earnings,  they  would  not  have  to  bear  the  risk  of  issuing  common  stock,   which  is  a  relatively  riskier  way  for  raising  funds.  Therefore,  firms  tend  have  requirements   on  their  payout  ratio  to  make  sure  certain  degrees  of  investment  can  be  satisfied  simply   by  internal  financing.  According  to  the  latest  research  on  this  theory,  pecking  order  theory   cannot  generally  apply  to  all  enterprises.  Different  orders  are  described  in  financing  of   firms   in   emerging   markets   and   developed   market.   Firms   in   developed   countries   like   American  corporations  tend  to  perfectly  follow  “pecking  order  theory”.  They  initially  rely   on  internal  funds,  then  seek  external  financing  sources  like  debt  issues  or  equity  financing.   But  in  the  case  of  Chinese  firms,  the  proportion  of  external  financing  is  bigger  than  internal   financing,  and  equity  financing  is  the  most  preferred  method  (Zhou,  2011).  Table  1  in   appendices   proves   the   pecking   order   theory   by   providing   evidence   from   several   developed  countries.   2.3  Theory  based  on  agency  costs     Agency  cost  comes  down  to  the  separation  of  ownership  and  management.  When  firms   hire  managers  to  run  the  organisation  on  their  behalf,  a  gap  emerges  because  these  two   groups   have   conflicts   of   interests   and   managers   own   the   comparative   advantage   of   information.     Jensen  and  Meckling  (1976)  emphasises  the  existence  and  importance  of  agency  costs   in  their  paper,  and  classify  the  models  based  on  agency  costs  into  two  categories.  The  
12 first  conflict  exists  between  managers  and  equity  holders.  In  order  to  test  the  action  of   managers,  they  divided  equity  into  two  parts  -­-­-­  inside  and  outside,  based  on  whether  the   equity  is  held  and  used  by  the  managers.  Inside  equity  is  the  part  that  is  accessible  for   managers   and   vice   versa.   It   turns   out   that   managers   tend   to   use   resources   and   information  held  for  their  own  benefit,  which  is  normally  against  the  interests  of  equity   holders.  In  a  word,  agency  cost  arises  due  to  the  conflicts  between  a  manager’s  behaviour   and  an  equity  owner’s  benefit.  The  second  conflict  arises  from  the  conflict  between  firm’s   equity   holders   and   its   debt   holders.   Provided   that   equity   holders   make   a   high-­risk   investment,  which  may  provide  them  with  high  yield  of  return  on  the  condition  that  it  is   successful.  However,  under  the  circumstance  of  failure,  debt  owners  suffer  from  loss  of   interest  or  even  principal.  Thus,  equity  holders  have  the  motivation  to  choose  investments   with  extra  risk,  which  can  be  a  hazard  to  debt  holders  due  to  the  higher  default  possibility.   The   idea   that   equity   owners   use   risky   investment   to   transfer   risk   and   liability   to   debt   owners  is  called  the  “asset  substitution  effect”  or  “risk-­shifting  hypothesis”.  Figure  2  in   appendices  explains  firm’s  process  of  reaching  the  optimal  capital  structure.   2.3.1  Managerial  entrenchment  theory       Managerial  entrenchment  theory  emphasises  that  managers  value  their  own  position  or   ventures  more  than  the  optimum  capital  structure  and  interests  of  shareholders.  Novaes   and  Zingales  (1995)  believe  that  managers  and  shareholders  hold  different  views  towards   debt.  Stakeholders  of  firms  tend  to  consider  debt  as  a  tool  of  efficiency  maximisation.   Nonetheless,  managers,  who  are  actually  making  the  business  decisions,  regard  debt  as   a  defensive  mechanism.  Zwiebel  (1996)  started  by  simply  discussing  the  advantages  and   disadvantages  of  managers’  accessibility  to  funds.  He  also  states  that  when  firms  are   highly  valued,  managers  tend  to  avoid  debt  and  do  not  rebalance  the  capital  structure   with  debt  for  personal  interest.  Managers  generally  face  two  major  threats:  bankruptcies   and  takeovers.  Debts  may  lead  to  bankruptcy;;  and  thus,  managers  avoid  accumulating   debt  for  their  own  benefit.  In  order  to  strengthen  individual  entrenchment,  managers  will   make  different  decisions  on  capital  structure.    
13 2.4  Market  timing  theory     Stein  (1996)  was  the  first  one  to  propose  the  idea  of  a  “market  timing  hypothesis”.  The   hypothesis  states  that  the  stock  market  is  irrational,  and  that  price  cannot  precisely  reflect   the  intrinsic  value  of  stocks.  When  a  firm’s  stock  price  is  overestimated,  rational  managers   are  supposed  to  issue  more  shares  to  take  full  advantage  of  investor  overenthusiasm.  On   the  contrary,  when  a  firm’s  stock  price  is  underestimated,  a  strategy  of  share  repurchasing   should  be  adopted  by  the  managers.     Baker  and  Wurgler  (2002)  also  raised  a  new  theory  about  capital  structure,  called  the   market  timing  theory.  They  describe  the  relationship  between  the  capital  structure  and   market  timing  as  “capital  structure  is  the  cumulative  outcome  of  attempts  to  time  the  equity   market”.  Their  concept  can  be  viewed  as  a  breakthrough  in  this  field  because  it  does  not   necessarily  require  the  hypothesis  of  rational  investors  and  perfect  arbitrage  as  does  the   traditional  theory  of  capital  structure.     2.4.1  Windows  of  opportunity  hypothesis     To  further  discuss  market-­timing  theory,  it  should  start  with  the  “windows  of  opportunity”   hypothesis  since  Baker  and  Wurgler’s  concept  is  based  on  the  empirical  studies  of  this   hypothesis.  Windows  of  opportunity  describes  the  existence  of  a  best  period  of  time  to   capitalise  on  events.  In  particular,  the  issue  of  the  initial  public  offering  (IPO)  is  a  case  of   windows   of   opportunity.   For   some   stocks   with   high   potential   such   as   Apple   Inc.,   the   window  of  opportunity  is  small  during  the  IPO  times  because  the  stock  price  will  increase   rapidly  later.  A  window  of  opportunity  is  also  associated  with  market  mispricing,  which   can   be   rectified   by   traders   after   they   realise   it.   In   short,   the   window   of   opportunity   hypothesis  indicates  that  the  time  of  IPO  issue  is  vital  for  the  future  development  of  a  firm,   and  how  well  managers  can  seise  the  short  period  of  opportunity  decide  the  amount  of   value  the  managers  can  create  for  shareholders.    
14   Table  1  Various  Equity  Choices  under  “Windows  of  Opportunity”   Table  1  is  referred  from  the  article  “The  long-­‐run  performance  of  initial  public  offerings”  of   Ritter  (1991),  the  research  found  that  the  under-­pricing  of  IPOs  is  normal,  but  it  exists   only  in  the  short  term.  In  the  long  term,  these  IPOs  underperform.  People  tend  to  become   over-­confident   about   the   future   returns   of   these   new   stocks   and   firms   fully   utilise   the   “window  of  opportunity”.  In  practice,  firms  choose  to  go  public  whenever  they  think  firm’s   stocks  are  overpriced.  The  action  that  the  firm  try  to  obtain  benefits  from  the  mispricing   can  be  considered  as  an  attempt  in  equity  market  timing.  In  particular,  he  illustrated  the   situation   by   listing   various   financing   orders   a   firm   tends   to   choose   under   different   circumstances.   Baker  and  Wurgler  (2002)  considered  two  types  of  equity  market  timing:  One  is  perceived   mispricing,  and  the  other  one  is  adverse  selection.     2.4.2  Perceived  mispricing     The   premise   of   this   section   is   that   managers   or   investors   are   irrational.   From   the   perspective   of   investors,   their   enthusiasm   will   drive   the   stock   price   higher   and   consequently  lead  to  overvalued  stocks.  Similarly,  investors’  depressed  emotions  may  be   the   impetus   for   declining   stock   prices   and   results   in   undervalued   stocks.   From   the   perspective   of   managers,   they   tend   to   issue   equity   if   they   consider   that   the   cost   is   relatively  low  and  repurchase  shares  if  they  believe  that  the  cost  is  relatively  high  (Chazi,   2004).  In  sum,  the  irrational  behaviours  of  both  investors  and  managers  lead  to  time-­ varying  mispricing.  Jenter  (2005)  supported  this  point  of  view  and  stated  that  managers   make  equity  decisions  based  solely  on  their  perceived  mispricing,  instead  of  a  real  need  
15 for  capital.  Under  this  situation,  if  a  firm  does  not  achieve  its  optimal  capital  structure,  and   managers   do   not   adjust   them   later,   the   temporary   change   in   stock   price   will   have   a   persistent  influence  on  capital  structure.     2.4.3  Adverse  selection     Adverse   selection   is   essentially   caused   by   asymmetric   information.   The   problem   of   information   asymmetry   is   common   in   the   business   world,   and   it   was   first   studied   by   George  Akerlof,  who  was  the  winner  of  2001  Economic  Nobel  Prize.  According  to  Akerlof   (1970),  due  to  the  presence  of  asymmetric  information,  buyer  and  seller  tend  to  hold   different   perceived   value   of   the   same   good,   and   the   difference   results   in   the   undervaluation  of  goods  with  premium  quality.  Finally,  inferior  goods  are  left  and  traded   on  the  market  instead  of  those  with  high  quality.     Ross  (1977),  Brealey,  Leland  and  Pyle  (1977)  stated  that  if  managers  make  decisions  on   capital   structure   based   on   inside   information,   the   choice   will   signal   information   to   outsiders  in  the  market,  and  this  theory  is  called  Signaling.  Myers  and  Majluf  (1984)  wrote   that   managers   of   the   firm   are   supposed   to   know   more   about   their   investment   than   investors,  which  can  cause  mispricing  in  the  market.  To  be  more  specific,  since  outside   investors  do  not  have  access  to  inside  information,  they  will  evaluate  a  firm  in  a  relatively   objective  way  with  a  mean-­reverting  value.  However,  managers  acquire  more  information.   When  they  face  favourable  news,  managers  will  avoid  issuing  equity  because  they  know   shares  are  underestimated.  Contrastingly,  when  they  receive  bad  news,  they  will  issue   equity  because  stocks  are  overvalued  at  this  time  compared  to  the  estimation  of  outsiders.   Once  they  make  the  issue  choices,  the  action  will  signal  information  to  outsiders,  and  thus   the  price  of  stock  will  drop  significantly  after  issue.   Baker  and  Wurgler  (2002)  drew  several  conclusions  in  their  paper:  1)  Equity  market  timing   indeed   affects   capital   structure   as   leverage   has   significant   negative   correlation   with   weighted  average  historical  market  value.  In  their  empirical  study,  they  broke  the  change   in  leverage  into  three  parts,  which  are  change  in  net  equity  issue  (e/A),  newly  retained   earnings  (∆RE/A)  and  the  net  debt  issue  as  the  residual  change  in  assets  (∆A/A-­∆E/A-­ ∆RE/A).  The  results  show  that  the  effect  of  M/B  value  to  leverage  mainly  comes  from  new  
16 equity  issue,  and  higher  M/B  value  leads  to  higher  amounts  of  issued  equity.  2)  The  effect   of  market  timing  actions  to  leverage  is  persistent  as  the  weighted  average  market  value   have  more  than  ten  years  of  influence  on  capital  structure.  Though  Baker  and  Wurgler   (2002)  proposed  two  types  of  market  timing,  they  did  not  distinguish  them  from  each  other   in  their  results.     After  Baker  and  Wurgler,  scholars  have  done  further  investigations  in  this  field  and  have   found  more  evidence  to  prove  the  theory.  Hovakimian  et  al.,  (2004)  discovered  in  their   paper  that  the  market  to  book  ratio  and  stock  returns  have  significant  influence  on  the   timing  of  equity  issues.  The  timing  of  issuing  stocks  depends  on  market  conditions,  and   they  found  firms  tend  to  issue  new  shares  after  a  notable  increase  in  stock  price.  Similarly,   Asquith  and  Mullins  (1986)  found  that  a  certain  price  pattern  is  associated  with  equity   market  timing.  The  price  of  stocks  is  generally  high  and  overvalued  before  the  issues  of   IPO.  However,  the  issue  of  stock,  or  to  be  more  accurate,  the  announcement  of  issue,  is   often  followed  by  decline  in  share  prices.  Another  survey  made  by  Graham  and  Harvey   (2002)  further  confirm  the  existence  of  equity  market  timing  by  managers.  They  surveyed   about  4440  companies  and  received  responses  in  the  form  of  392  finished  surveys,  and   found   that   the   action   of   equity   market   timing   is   common   in   modern   corporations.   In   addition,  firms  are  reluctant  to  resort  to  equity  issuing  because  they  do  not  want  to  dilute   their  earning  per  share  (EPS)  and  they,  following  trade-­off  theory,  want  to  set  a  target   debt  ratio  and  try  to  achieve  a  target  capital  structure  in  operations.     Furthermore,  on  the  question  of  whether  equity  market  timing  will  bring  capital  structure   a  continuous  influence,  Baker  and  Wurgler  (2002)  reported  their  result  as  a  persistent   one,  which  can  last  about  ten  years.     Huang  and  Ritter  (2009)  prove  the  long  lasting   influence  of  market  timing  in  their  empirical  study.  They  found  that  companies  choose  the   method  of  raising  funds  by  selecting  the  one  with  lower  cost  and  follow  the  pecking  order   theory  about  the  priority  of  internal  or  external  financing.  However,  Alti  (2006)  stated  in   his   paper   that   equity   market   timing   indeed   performs   as   a   critical   determinant   for   firm   financing  in  the  short  term,  but  it  become  less  important  as  time  goes  by,  as  he  found  the   effect   of   market   timing   to   be   diminishing   in   the   long   term   and   eventually   vanish.   In   accordance  with  Alti  (2006),  and  Flannery  and  Rangan  (2006),  they  claimed  that  the  effect  
17 of  market-­timing  is  temporary  because  a  firm’s  debt-­equity  ratio  adapts  to  changes  rapidly,   and  corresponding  adjustments  will  make  it  always  be  consistent  with  their  target  ratio.       Table  2  Summary  of  Capital  Structure  Theories   Table  2  provides  a  summary  of  theories  about  capital  structure.  An  obvious  trend  can  be   observed  that  new  theories  do  not  assume  the  presence  of  an  optimal  capital  structure,   but  these  theories  all  take  asymmetric  information  into  consideration.  Market  timing  theory   absorbs  knowledge  from  previous  theories,  and  it  is  developed  based  on  the  windows  of   opportunity  hypothesis.  Thus,  market  timing  theory  is  a  quite  comprehensive  and  updated   one,  and  is  relevant  to  this  era.      
18 3.  Methodology     The  methodology  is  divided  into  two  sections.  The  first  one  is  variable  definition,  which   introduces  and  defines  variables  that  will  be  used  in  the  linear  regression.  The  second   part  includes  hypotheses  and  corresponding  regression  models.  In  particular,  it  provides   explanations  on  choosing  variables  in  each  model  and  the  reasons  behind  these  choices.   3.1  Variable  Definition     Following  the  method  of  Baker  and  Wurgler  (2002),  this  paper  focus  on  the  relationship   between   market   timing   and   capital   structure,   other   variables   will   be   held   as   control   variables.  Variables  can  be  classified  into  two  categories:  1)  Market  timing  indicators  and   2)  Determinants  of  capital  structure.   3.1.1  Market  timing  indicator     In  this  paper,  the  Market  to  book  value  (M/B)  t  is  chosen  as  the  indicator  of  market  timing   following  the  empirical  study  of  Baker  and  Wurgler  (2002).  Previous  literature  has  used   this  ratio  as  the  variable  to  represent  market  timing.  For  example,  Rajan  and  Zingales   (1995)   used   the   market-­to-­book   ratio,   and   as   expected,   the   ratio   has   a   negative   correlation  with  leverage.  In  addition,  Baker  and  Wurgler  (2002)  divided  the  leverage  into   three  parts,  and  found  that  the  market-­to-­book  value  has  significant  positive  correlation   with  the  equity  issues.  Market-­to-­book  ratio  here  is  defined  as  the  result  of  total  asset   minus  book  equity  and  plus  market  capitalisation  divided  by  total  assets.     However,  whether  the  Market-­to-­book  ratio  can  be  considered  as  a  precise  proxy  for   market  timing  behaviour  is  still  controversial.  Hovakimian  (2006)  studied  firms  in  America   and  cannot  find  a  direct  and  significant  influence  of  market-­to-­book  ratio  on  the  capital   structure.   Instead,   he   found   an   inverse   relationship   as   a   result   of   the   larger   growth   potentials,  which  means  firms  possess  more  opportunity  to  expand  by  issuing  more  equity.   Thus,  some  scholars  replace  market-­to-­book  ratio  with  other  variables  as  indicators  of   market   timing   behaviour.   For   instance,   by   dividing   months   into   hot   months   and   cold   months,  Alti  (2006)  built  the  dummy  variable  of  “HOT”,  if  firm  issue  IPO  in  hot  months,  the  
19 value  is  1  otherwise  it  will  be  0.  Chazi  and  Tripathy  (2007)  use  insider  trading  as  an   alternative  method.       Table  3  Summary  of  Different  Choices  on  Market-­timing  Indicators   In  the  article  “A  Test  of  the  Market  Timing  Theory  in  China-­-­-­econometric  evidence  from   the   Chinese   listed   companies”   of   Liu   and   Li   (2005),   theories   are   divided   into   three   categories.   Table   3   chooses   and   organises   only   theories   that   concern   the   appropriateness  of  using  M/B  as  an  indicator  of  market  timing.  Table  3  also  summarised   different  indicators  for  market  timing  and  listed  the  main  conclusion  of  these  empirical   studies.     When  testing  the  persistent  effect  of  the  market-­to-­book  ratio  on  capital  structure,  Baker   and  Wurgler  (2002)  introduced  a  modified  variable  (M/Befwa)  into  their  model.  
20   The  variable  shown  in  the  figure  is  the  external  finance  weighted-­average  market-­to-­book   ratio.  The  variable  is  initially  introduced  in  the  paper  “Market  timing  and  capital  structure”   by   Baker   and   Wurgler   (2002),   and   they   described   it   as   it   “summarizes   the   relevant   historical  variation  in  market  valuations”.  Their  results  show  that  if  firm  raise  capital  from   external   financing   when   their   stocks   are   overvalued,   the   external   finance   weighted-­ average  M/B  ratio  will  subsequently  provide  high  value  even  if  they  eventually  choose   debt  or  equity  issuing.  This  number  directly  reflects  external  financing  actions  of  a  firm,   and  thus  firms  who  use  external  capital  more  frequently  will  observe  higher  values.  They   believe  the  new  measurement  is  better  than  simply  adding  a  lagged  M/B  ratio  because  it   points  out  which  of  those  lags  are  most  relevant  in  a  precise  way.   They  do  not  allow  negative  value  of  this  variable  as  they  have  to  make  sure  they  are   averaged  results.  The  minimum  of  this  value  is  zero  and  it  represents  that  no  information   of  market  change  is  reflected  by  the  variable  in  that  year.  Most  importantly,  all  of  these   restrictions   are   applied   to   avoid   the   weighted   number   increasing   with   the   increase   in   external  capital  in  each  period,  as  the  number  is  supposed  to  show  the  effect  of  historical   market  valuation  and  should  not  be  correspond  with  time.   3.1.2  Capital  structure  and  determinants     Leverage  itself  will  be  presented  by  the  ratio  of  debt  and  assets,  and  both  book  and   market  leverage  will  be  tested.  Three  other  relevant  variables  first  applied  by  Rajan  and   Zingales   (1995),   which   is   also   referred   to   Baker   &   Wurgler   (2002),   are   profitability   (EBITDA/At),  firm  size  Log  (St)  and  assets  tangibility  (PPE/At).   Leverage   Leverage  is  the  most  straight-­forward  and  precise  indicator  for  a  firm’s  capital  structure.   This  paper  uses  the  ratio  of  debt  to  total  assets  (D/At)  to  represent  leverage.  Both  book  
21 leverage  and  market  leverage  are  taken  into  consideration  in  this  model.  Book  leverage   (D/At)  is  calculated  as  book  debt  (D)  divided  by  total  assets  (A)  and  market  leverage  (D/At)   m  is  calculated  as  book  debt  divided  by  the  result  of  total  assets  minus  book  equity  (Eb)   and  plus  the  market  capitalisation  (Em).   Profitability   According  to  pecking  order  theory,  profitability  has  a  negative  relationship  with  leverage   because   high   earnings   allow   firms   to   acquire   capital   internally.   Hence,   firms   do   not   necessarily  need  to  raise  capital  from  external  sources.  Baker  and  Wurgler  (2002)  proved   that  profitability’s  effect  on  leverage  is  mainly  from  retained  earnings,  and  the  net  effect   of  higher  profitability  is  leverage  reduction.  However,  as  stated  in  trade-­off  theory,  firms   with   stronger   profitability   also   bear   heavier   tax   burdens   as   a   result   of   higher   profit.   Therefore,   they   will   have   stronger   motivation   to   issue   debt,   which   provides   firms   the   opportunity   to   benefit   from   tax   shields.   Additionally,   higher   profitability   indicates   less   possibility  of  bankruptcy,  which  means  that  firms  with  higher  profitability  generally  have   lower  bankruptcy  costs.  Thus,  firms  tend  to  choose  relatively  high  levels  of  debt  as  the   method  of  financing.  Under  the  pecking  order  theory,  higher  profitability  means  firms  own   more  internal  capital,  and  thus  will  use  less  leverage.     Profitability  (EBITDA/At)  is  calculated  as  earnings  before  interest,  taxes,  depreciation  and   amortisation  divided  by  total  assets,  and  expressed  in  terms  of  percentage.     Size   A  firm’s  size  is  also  associated  with  the  degree  of  leverage.  Traditional  trade-­off  theory   believes  larger  firms  will  be  more  likely  to  choose  debt  financing,  because  risk  can  be   diversified  by  wider  range  of  operation  activities,  unless  the  firm  is  facing  a  financial  crisis.   However,  Rajan  and  Zingales  (1995)  anticipated  that  larger  firms  have  less  problems  with   asymmetric  information,  and  hence  tend  to  select  equity  financing  when  compared  to   smaller   firms.   Beck   et   al.   (2008)   also   proves   the   importance   of   firm   size   in   financing   decisions  of  companies.  Their  study  found  a  negative  correlation  between  firm  size  and   usage  of  external  financing.  In  another  words,  they  confirm  that  larger  firms  tend  to  use   external  capital  more  frequently  than  smaller  ones.  
22 Firm  size  log(St)  is  defined  as  the  log  of  net  sale/revenues.   Tangibility   Generally,  if  a  firm  holds  large  quantity  of  tangible  assets,  they  will  be  more  willing  to  use   debt  because  fixed  assets  are  normally  considered  as  collateral  of  debt.  Thus,  higher   tangibility  indicates  higher  capacity  of  using  debt,  and  the  majority  of  studies  discover  a   positive  relationship  between  the  amount  of  fixed  assets  and  the  level  of  leverage.  The   result  is  also  in  line  with  both  trade-­off  theory  and  pecking  order  theory.     Tangibility  (PPE/At)  here  is  defined  as  net  property,  plant  and  equipment  divided  by  total   assets  in  percentage  terms.  In  some  literature,  tangibility  is  also  known  as  the  ratio  of   fixed  assets  to  total  assets.     Growth   The  growth  opportunity  of  a  firm  is  measured  as  Tobin’s  q.  This  measurement  is  proposed   by  Tobin  (1969)  to  assess  the  growth  opportunity  of  a  firm.  Generally,  the  Tobin’s  q  has   a   negative   relationship   with   the   degree   of   leverage.   A   firm   with   the   larger   growth   opportunity  tends  to  rapidly  expand  their  business  and  the  process  is  accompanied  with   huge  expenditure.  Thus,  companies  are  reluctant  to  use  debt  in  order  to  avoid  heavy  debt   burdens  or  even  financial  collapse.  In  research  by  Shyam-­Sunder  and  Myers  (1999),  the   importance  of  growth  opportunity  as  well  as  the  inverse  relationship  between  Tobin’s  q   and   leverage   was   proven.   On   the   basis   of   traditional   trade-­off   theory,   the   negative   relationship  is  reasonable  as  it  stated  that  firms  with  higher  growth  rates  may  suffer  from   higher  bankruptcy  costs  when  using  debt.  However,  the  inverse  relationship  seems  to   have   some   conflict   with   pecking   order   theory,   which   claims   the   growth   opportunities   should  be  supported  by  debt  financing  instead  of  equity.  In  short,  there  is  a  negative   relationship  between  growth  opportunities  and  leverage  under  trade-­off  theory,  while  it  is   positive  under  pecking  order  theory.   Tobin’s  q  (or  the  q  ratio)  is  defined  as  total  market  value  of  firm  divided  by  total  assets.  
23 However,  there  is  similarity  in  calculations  of  Tobin’s  q  and  Market-­to-­book  value.  They   have  a  Pearson  correlation  of  1,  which  means  they  have  multi-­collinearity  in  the  initial   analysis.  Hence,  this  variable  is  abandoned  from  the  linear  regression.     Table  4  Summary  of  Variable  Definitions   Table  4  gives  a  summary  of  variable  definitions.  All  of  them  originally  follow  the  research   of  Fama  and  French  (2000).  Many  studies  like  research  of  Yu  (2008)  have  also  cited   these  variable  definitions.   3.2  Hypothesis  and  Models     This  paper  aims  to  answer  three  questions:  1)  Whether  market  timing  exists  in  Hong  Kong   listed   companies;;   2)   Whether   market   timing   will   have   short-­term   influence   on   capital   structures;;   and   3)   Whether   market   timing   will   have   long-­lasting   (more   than   10   years)   influence  on  capital  structure.   Based  on  the  result  of  the  market  timing  theory  test  in  Baker  and  Wurgler  (2002),  three   hypothesis  corresponding  to  the  three  questions  are  stated  in  this  part.  
24 3.2.1  Hypothesis  1  Existence  of  Market  timing     Hypothesis  1:  Market  timing  exists  both  in  debt  and  equity  financing  of  Hong  Kong  listed   companies   Research  by  Hovakimian  te  al  (2001)  found  that  firms  face  obstacles  in  achieving  their   optimal  capital  structure.  In  order  to  reach  the  target  debt  ratio,  a  firm  has  to  choose   whether  to  repurchase  equities  or  retire  debts,  a  process  which  is  highly  related  to  market   timing.  Furthermore,  according  to  Hovakimian  (2004),  equity  market  timing  depends  on   the  market  situations.  Under  the  circumstance  of  good  market  performance,  the  market   to  book  value  will  be  higher,  and  firms  tend  to  issue  equity  to  raise  capital;;  under  a  more   bearish  market,  which  is  reflected  in  lower  market  to  book  value,  firms  tend  to  repurchase   shares.   Model  1  Existence  of  equity  market  timing  in  Hong  Kong  listed  company     Model  1  aims  to  test  the  relationship  between  market-­to-­book  value  with  two  different   ways  of  external  financing,  while  simultaneously  controlling  for  the  last  three  variables.   Yt=  (EQUI/At,  DEBT/At,  DEBT/At,m)   Yt  here  is  the  dependent  variable,  which  represents  three  indicators:  1)  Amount  of  net   equity  financing  divided  by  total  assets  (EQUI/A)  t;;  2)  Book  leverage  (DEBT/A)  t;;  3)  Market   leverage  (DEBT/A)  t,m.  These  three  variables  are  used  to  test  whether  market  timing  exist   in  debt  financing  or  equity  financing.  Both  book  and  market  leverage  are  used  in  order  to   conduct  a  more  comprehensive  investigation.   (M/B)  t  is  the  market  to  book  value,  which  is  the  indicator  of  market  timing  behaviour.  If   the  market  timing  theory  holds,  this  ratio  will  exhibit  a  positive  relationship  with  equity   financing  and  a  negative  one  with  leverage,  because  higher  market  to  book  ratio  indicates  
25 the  market  is  in  a  state  of  flourishing,  and  a  firm’s  stock  is  more  likely  to  be  overvalued,   leading  the  firm  to  choose  issue  equity.     There  are  three  control  variables  here:  (EBITDA/A)  t,  log  (S)  t  and  (PPE/A)  t.  These  three   determinants  of  capital  structure  are  used  in  Model  1  in  order  to  test  how  they  will  affect   financing  behaviour.     (EBITDA/A)  t  is  the  Earnings  before  interest,  tax,  depreciation  and  amortisation  divided  by   total  assets  and  expressed  in  percentage  form.     log  (S)  t  is  the  log  of  net  sale  of  firm.   (PPE/A)  t  is  Net  property,  plant  &  equipment  divided  by  total  assets  and  expressed  in   percentage  form.   3.2.2  Hypothesis  2:  Short-­term  effect     Hypothesis  2:  Market  timing  behaviour  has  short-­term  effects  on  the  capital  structure  of   Hong  Kong  listed  companies   Plenty  of  literature  have  proven  the  short-­term  effect  of  both  equity  and  debt  market  timing.   However,  Liu  and  Li  (2005)  held  a  negative  result  in  China.  They  found  that  though  equity   market-­timing   behaviour   exists   in   the   Chinese   market,   they   do   not   have   significant   influence  on  firms’  capital  structures.  This  paper  still  assumes  there  is  a  short-­term  effect   in  Hong  Kong  listed  companies,  because  the  research  of  Liu  and  Li  (2005)  indicates  the   market-­timing  theory  is  not  a  suitable  application  for  emerging  market,  while  Hong  Kong   is  a  developed  area.   Model  2:  Short-­run  effect  of  equity  market  timing  on  capital  structure     Model  2  aims  to  test  the  short-­term  effects  of  market-­timing.  Hence  the  data  from  the  last   period  is  also  used  in  order  to  test  the  relationship  between  the  change  of  leverage  and   market-­timing  behaviour.  
26 (D/A)t-­(D/A)t-­1   is   the   dependent   variable   in   this   model,   which   represents   the   change   between  leverage  in  this  period  and  that  of  the  last  one.  Both  book  and  market  leverage   are  tested  in  the  linear  regression.     (D/A)t-­1  is  a  lagged  leverage  variable  and  is  restricted  between  0  and  1.  In  Baker  and   Wurgler  (2002),  the  lagged  average  has  a  negative  sign,  but  they  did  not  report  it  in  their   results.  They  use  this  variable  in  their  model  because  they  are  restricted  to  a  certain  range,   which  means  they  can  only  go  in  one  direction,  and  thus  it  can  be  used  as  a  control   variable.   Other  variables  are  same  as  that  in  the  last  model,  except  that  data  from  previous  periods   is  used  here.   3.2.3  Hypothesis  3:  Persistent  effect     Hypothesis  3:  Market  timing  behaviour  has  persistent  effect  on  capital  structure  of  Hong   Kong  listed  companies   As   mentioned   in   the   literature   review   part,   the   “external   finance   weighted-­average"   market-­to-­book  ratio  is  used  as  a  proxy  of  accumulated  historical  market  valuation.  Some   researches   confirm   the   long-­lasting   effect,   such   as   Huang   and   Ritter   (2009),   but   Alti   (2006),  Flannery  and  Rangan  (2006)  doubt  the  presence  of  persistent  effects  of  market   timing  as  they  only  proved  the  temporary  influence  and  failed  to  find  the  long-­term  one.   Followed  the  study  of  Baker  and  Wurgler  (2002,  this  dissertation  hypothesises  that  the   persistent  effect  exists.     Model  3:  Persistent  effect  of  equity  market  timing  on  capital  structure       Model  3  mainly  focuses  on  the  effect  of  the  accumulative  change  since  the  IPO,  and  is   designed  to  compare  the  effect  between  the  external  finance  weighted-­average  market-­ to-­book  value  (M/B)efwa  and  the  lagged  market  to  book  value  (M/B)t-­1.  
27 (M/B)efwa   is   the   external   finance   weighted-­average   market-­to-­book   value,   which   represents  the  accumulated  historical  effect  of  equity  market  timing  behaviour.  However,   the  market  to  book  value  is  also  applied  in  this  model  to  distinguish  the  accumulative   effect  and  the  periodical  influence  from  the  last  period.     The  dependent  variable  simply  adopt  leverage  but  not  the  change  of  leverage  like  in  the   Model  2  because  (M/B)efwa  is  already  contains  historical  information.  Thus,  the  persistent   effect  since  the  IPO  time  to  each  period  can  be  directly  observed  by  using  periodical   leverage.   Other  variables  are  the  same  as  that  in  the  last  model.        
28 4.  Data     This   paper   use   both   the   Bloomberg   database   and   the   Thomson   One   DataStream   database.   The   Bloomberg   database   is   used   to   generate   the   list   of   companies   which   issued   IPOs   from   2005   to   2015   in   the   Hong   Kong   stock   market,   together   with   the   International  Securities  Identification  Numbers  (ISIN)  of  those  IPOs.  Subsequently,  by   using  their  ISIN  code,  specific  data  for  variables  like  Market  to  book  ratio  is  acquired  from   the  DataStream  database.  Data  is  processed  by  IBM  SPSS  23.0.  The  main  statistical   method  is  linear  regression  and  t-­test  of  sample.     There  are  two  types  of  samples:  1)  IPO  subsample,  and  2)  Calendar  year  sample.     According   to   different   offer   times   of   different   IPOs,   data   is   classified   into   several   subsamples  as  IPO,  IPO+1,  IPO+3,  IPO+5,  IPO+7  and  IPO+9.  For  instance,  if  firm  A   issued  an  IPO  in  2000,  data  for  this  firm  in  2001  will  be  included  into  the  subsample  of   IPO+1.  Equivalently,  if  firm  B  issue  IPO  in  2005,  data  for  this  firm  in  2006  will  be  included   into  the  subsample  of  IPO+1.  Thus,  one  subsample  (like  IPO+1)  can  contain  data  of   different   companies   in   different   years.   Eventually,   data   of   227   Hong   Kong   listed   companies  within  the  eleven-­year  period  (including  the  pre-­IPO  year)  is  required  and  used   for  analysis  in  this  paper.  In  IPO  subsamples,  the  subject  of  observation  is  the  individual   firms.  Classifying  data  into  samples  according  to  time  makes  it  easier  to  understand  how   a   firm’s   leverage   or   financing   structure   changes   since   the   issue   of   its   IPO.   Detailed   changes  in  each  year  can  be  required  from  running  regressions  in  each  subsample.   Compared  to  IPO  subsamples,  calendar  year  samples  are  more  integral.  The  duration  of   observation  in  this  dissertation  is  11  years  (includes  the  pre-­IPO  year),  and  calendar  year   subsamples  just  break  this  time  period  into  4  parts.  For  example,  in  the  first  subsample   of  2005-­2007,  data  of  IPOs  issued  in  2005,  2006  or  2007  will  be  included.  Also,  the  IPO+1   and  IPO+2  subsamples  data  of  a  firm  that  issues  its  IPO  in  2005  will  be  included  as  well   because  for  this  company,  IPO+1  means  the  year  of  2006  and  IPO+2  means  that  of  2007.   Calendar  year  samples  focus  more  on  the  market  trend  as  it  assesses  all  firms  in  a  certain   time  period  together,  and  it  allows  an  individual  firm  to  be  observed  multiple  times.  
29 Similar  to  the  majority  of  empirical  studies,  in  order  to  winsorise  our  sample,  this  paper   excludes  companies  that:  1)  Are  in  financial  industry,  due  to  the  characteristic  of  financial   corporations  (Liu  and  Li,  2005);;  2)  Do  not  provide  consolidated  financial  statements;;  3)   Has  leverage  higher  than  1  or  lower  than  0  (Yu,  2008);;  and  4)  Has  market  to  book  value   over  10  (Baker  and  Wurgler  2002)  By  applying  these  conditions,  the  outliers  can  be  avoid   and  stationarity  can  be  improved,  especially  when  the  observing  time  horizon  includes   the  period  of  2008-­09  financial  crisis.        
30 5.  Results  and  Analysis     5.1  Existence  of  market  timing  behaviour       Table  5  Summarised  Statistics  of  Capital  Structure  and  Financing  Decisions   Table  5  summarises  the  statistical  results  of  the  analysis  looking  at  the  change  in  both   book  and  market  leverage  and  the  components  of  capital  structure.     Panel   A   organizes   data   by   IPO   subsamples,   and   6   different   sub-­samples   of   IPO   are   selected.  As  stated  in  the  section  on  data,  the  IPO  subsamples  are  designed  to  observe   trends  of  individual  firms.  A  decline  of  book  leverage  can  be  observed  after  the  IPO  issue.   The  trend  lasts  for  1  year  and  the  book  leverage  recovers  little  by  little  in  the  next  9  years.   The  process  is  slow  and  time-­consuming  as  it  takes  9  years  for  the  mean  value  of  book   leverage  to  recover  to  the  initial  level.  It  is  worth  noting  that  there  is  a  change  in  the   method   of   financing   after   the   issue   of   IPO.   In   the   IPO+1   sample,   the   portion   of   debt   finance  has  a  notable  increase  while  the  portion  of  equity  financing  has  an  inverse  change.   In  other  words,  after  the  issue  of  IPO,  firms  tend  to  change  their  way  of  raising  capital   from  equity  to  debt.     Panel  B  sorts  data  by  calendar  year.  In  this  sections,  samples  are  analysed  in  a  cross-­ sectional  manner  as  all  firms  during  that  period  of  time  are  observed  together,  and  the  
31 same   firm   may   be   observed   multiple   times,   and   thus   calendar   year   samples   more   accurately  reflect  the  general  market  situation.  The  overall  trend  is  the  increase  of  market   leverage  and  decrease  in  equity  issue.  The  increase  in  market  leverage  indicates  that  the   market  value  of  firms  is  becoming  lower,  thus  firm  will  not  issue  equity,  but  will  raise  capital   from  debt  instead.  According  to  the  market  timing  theory,  firms  issue  equity  when  the   market  value  is  high  (or  stocks  are  overvalued),  and  thus  the  amount  of  equity  issues   should  decrease  when  market  value  becomes  lower.  The  result  in  Table  5  is  consistent   with  market  timing  theory.   Market-­timing  behaviour  not  only  refers  to  equity  market  timing  in  stock  market,  it  also   includes   market   timing   of   debt   (Hovakimian,   2004).   The   Pearson   linear   correlations   between  the  two  dependent  variables  and  the  four  independent  variables  are  checked   before  running  the  linear  regression.  Results  are  shown  in  the  table  below.     Table  6  Pearson  Correlation  between  Variables   Results  from  Table  6  show  the  M/B  value  has  a  positive  correlation  with  net  equity  issue   and  a  negative  correlation  with  debt  financing.  It  also  shows  results  of  three  different   regressions,   where   the   dependent   variables   are   net   equity   issue,   book   leverage   and   market  leverage  respectively.  
32 Generally,  the  M/B  ratio  reflects  the  current  market  situation.  Higher  M/B  ratio  indicates  a   bull   market,   which   also   means   firm’s   share   price   has   higher   possibility   to   be   overestimated,   and   thus   firms   will   issue   IPOs   at   this   time   to   take   advantage   of   the   mispricing.  Contrastingly,  when  the  M/B  value  is  lower,  firms  will  switch  to  debt  financing   to   avoid   underestimation   of   their   stock   prices.   The   result   shows   when   the   M/B   ratio   changes  in  the  same  direction  with  equity  issue  and  changes  in  an  opposite  direction  with   leverage,  which  meets  the  expectations  of  market  timing  theory.   Profitability  here  has  a  positive  correlation  with  equity  financing  and  a  negative  one  with   leverage.   This   result   demonstrates   that   when   Hong   Kong   listed   companies   possess   stronger   profitability,   they   are   more   likely   to   raise   funds   internally   from   the   retained   earnings,  and  thus  the  amount  of  debt  will  decrease.  Equity  issuing  provides  firms  extra   funds,  thus  leading  to  higher  profitability.  Marsh  (1982)  explains  that  profitability  can  be   viewed  as  an  indicator  of  the  timing  effect,  as  firms  with  higher  earnings  tend  to  be  those   that  are  enjoying  significant  increases  in  stock  price.     Firm’s  size,  which  is  represented  by  the  log  value  of  net  sales,  show  a  positive  relationship   with  debt.  The  result  means  larger  Hong  Kong  listed  companies  are  more  willing  to  use   debt.  Larger  firms  are  usually  more  diversified.  Research  from  Wan  (1998)  pointed  out   that  Hong  Kong  firms  that  are  more  diversified  do  not  necessarily  have  higher  profitability.   Instead,   higher   levels   of   diversification   only   have   positive   effects   on   the   stability   of   profitability.  Hence,  larger  firms  with  a  wider  range  of  operations  are  more  willing  to  use   debt  because  they  have  stable  earnings,  and  thus  bear  less  risk.   Finally,   tangibility   has   a   positive   relationship   with   debt   use,   and   the   value   of   positive   correlation  is  higher  than  that  between  firm  size  and  debt.  The  result  shows  a  more  direct   and  positive  relationship  and  is  consistent  with  both  trade-­off  and  pecking  order  theory,   as  well  as  the  majority  of  empirical  studies  on  this  subject.  It  proves  the  importance  of   tangible  assets  as  collateral  in  borrowing  debt.   However,  the  Pearson  correlation  just  provides  a  general  glance  of  variables.  Precise   analysis  of  relations  between  variables  need  to  be  confirmed  by  the  coefficients  of  linear  
33 regression.   Applying   the   Model   1   introduced   in   the   methodology,   coefficients   among   variables  are  acquired  and  shown  in  the  table  below.     Table  7  Coefficients  of  Model  1a   Model  1a  is  designed  to  study  the  relationship  between  net  equity  issue  and  equity  market   timing  and  the  results  are  shown  in  Table  7.  Though  the  R-­square  of  this  model  is  0.083,   the  t-­test  of  all  independent  variables  are  highly  significant.  The  result  shows  the  market   to  book  value  has  a  significant  effect  in  issuing  equity  and  further  confirms:  1)  The  positive   relationship  between  equity  issue  and  equity  market  timing;;  2)  the  positive  relationship   between  equity  issue  and  profitability;;  3)  the  negative  relationship  between  equity  issue   and  firm  size;;  and  4)  the  negative  relationship  between  equity  issue  and  tangibility.     Table  8  Coefficients  of  Model  1b  &1c  
34 Table  8  summarises  results  of  book  leverage  and  market  leverage  by  applying  Model  1.   It  explains  that  market  timing  behaviour  is  an  important  issue  to  be  considered  when   making  debt  financing  decisions.  In  contrast  to  the  result  in  Model  1a,  it  further  proves:  1)   The  negative  relationship  between  debt  financing  and  firm’s  market  value;;  2)  the  negative   relationship  between  debt  financing  and  tangibility;;  3)  the  positive  relationship  between   debt  financing  and  firm  size;;  and  4)  the  positive  relationship  between  debt  financing  and   tangibility.   Based   on   all   results   from   linear   regressions,   hypothesis   1   cannot   be   rejected.   I   can   conclude  that  market  timing  behaviour  exists  both  in  equity  and  debt  financing  decisions   of  Hong  Kong  listed  companies.  Firms  choose  equity  issue  when  the  market  value  is  high   and  select  debt  financing  otherwise.     5.2  Short-­term  effects  of  market  timing  behaviour     Model  2  described  in  the  methodology  is  used  to  test  for  short-­term  effects.  Compared  to   Model  1,  the  dependent  variable  adopts  the  difference  of  leverage  of  current  period  and   that   of   the   last   period   in   order   to   test   the   effect   of   a   temporary   change   of   leverage.   Coefficients  of  variables  are  acquired  and  shown  in  the  table  below.     Table  9  Coefficients  of  Model  2a   According  to  Table  9,  all  variables  are  significant  at  1%  level  of  significance.    
35 Profitability  has  a  relative  strong  linear  relationship  with  the  change  in  capital  structure,   and  the  effect  is  negative.  As  stated  before,  the  result  meets  the  expectation  of  pecking   order  theory,  and  indicates  that  the  Hong  Kong  market  is  like  other  developed  markets   that   follow   the   financing   order   under   pecking   order   theory.   Higher   ability   to   generate   earnings  provides  firms  with  sufficient  internal  funds.     The  next  one  is  tangibility.  In  the  short-­run,  tangibility  plays  an  important  role  in  a  firm’s   capital  structure.  The  beta  shows  that  when  there  is  a  1  percent  increase  in  tangibility   (PPE/A  t),  there  will  be  a  0.12  percent  increase  in  the  book  leverage.     Compared  to  profitability  and  tangibility,  market  timing  seems  less  important  from  the   perspective   of   effect   on   capital   structure.   It   proves   that   though   a   manager’s   timing   behaviour  indeed  has  short-­run  influence  on  capital  structure,  how  much  it  changes  still   largely  depends  on  the  firm’s  willingness  and  ability  to  raise  debt.   The   lagged   term,   DEBTt-­1   has   the   strongest   correlation   with   the   change   in   leverage.   Similar  to  the  result  in  Baker  &  Wurgler  (2002),  the  relationship  is  strongly  negative,  but   they  did  not  report  the  statistical  result  of  this  variable  in  their  paper.  The  lagged  variable   is   included   because   the   amount   of   leverage   in   the   last   period   will   definitely   has   a   significant  influence  on  the  result  of  changes  in  leverage,  and  therefore  it  needs  to  be   controlled  in  order  to  avoid  adverse  effects  on  other  variables.       Table  10  Coefficients  of  Model  2b  
36 One  interesting  thing  is  that  the  result  of  market  leverage  always  has  higher  degree  of   significance  than  that  of  book  leverage  in  each  single  regression  thus  far.  Overall,  the   sign  of  results  of  market  leverage  are  the  same  as  those  in  the  previous  model.  However,   they  are  more  significant  and  the  model  has  higher  R-­squared.  One  possible  explanation   is  that  book  leverage  reflects  more  about  the  operation  of  a  company  and  will  be  modified   before  publishing,  but  market  leverage  contains  more  information  about  the  market,  and   thus  will  be  more  sensitive  and  will  express  the  change  more  accurately.  Adrian  et  al   (2015)  stated  in  their  staff  report  of  the  Federal  Reserve  Bank  of  New  York  that  “market   leverage  is  nearly  entirely  reflective  of  movements  in  book-­to-­  market  ratios”.  Therefore,   market  leverage  tends  to  have  more  significant  results.     Model  2  is  designed  to  test  the  short-­term  effect  of  market  timing  behaviour  on  capital   structure.  According  to  the  results  of  the  t-­test,  hypothesis  2  cannot  be  rejected.  In  short   time  horizons,  market  timing  has  significant  influence  on  financing  actions  and  has  direct   effects  on  changes  of  leverage.  However,  the  primary  reason  behind  the  change  is  firms’   desire  and  ability.   5.3  Persistent  effect  of  market  timing  behaviour     Model  3  introduces  a  new  variable  created  by  Baker  &  Wurgler  (2002).  First  of  all,  data   of  all  time  periods  is  analysed  in  a  cross-­sectional  manner  in  the  regression,  and  the  result   is  shown  in  the  table  below.     Table  11  Coefficients  of  Model  3a  
37 From   Table   11   shows   that   during   the   ten-­year   period,   both   (M/B)efwa   and   (M/B)t-­1   are   significant,  but  the  periodical  market  timing  seems  much  more  closely  related  to  leverage   than  the  accumulated  historical  behaviour.  In  this  model,  the  result  indicates  that  instead   of  past  timing  actions,  the  periodical  adjustment  of  a  firm’s  leverage  has  greater  influence   on  its  capital  structure.  This  outcome  is  more  likely  to  follow  the  trade-­off  theory  that   managers   rectify   and   rebalance   for   the   target   capital   structure   based   on   the   current   market  situation.  However,  Baker  &  Wurgler  (2002)  emphasizes  that  market  timing  is  the   result  of  accumulated  actions  of  timing,  and  the  impact  of  (M/B)efwa  is  obviously  more   significant  and  accurate  than  the  variable  of  (M/B)t-­1.  This  model  only  examines  from  a   single  point  of  time,  and  cannot  show  the  continuous  change  from  year  to  year.  Hence,   in  order  to  further  compare  influence  of  these  two  variables,  detailed  statistical  analysis   in  each  subsample  is  necessary.   Instead  of  using  cross-­sectional  data,  time-­series  regressions  of  each  subsample  are   presented  in  the  table  below.     Table  12  Summary  of  coefficients  in  subsamples1   Results  of  four  subsamples,  including  IPO+1,  IPO+3,  IPO+5  and  IPO+10,  are  shown  in   Table  12.  Coefficients  of  all  firms  from  2005  to  2015  have  already  been  illustrated  in  Table   11,  but  are  shown  here  to  facilitate  comparison.     1 Subsample of IPO+10 here combines the data of IPO+9 and IPO+10 because initially there are only 26 companies in the IPO+10, which is less than 30, and the small sample size may cause bias in the result. Thus data from the end of IPO+9 is added.
38 As  can  be  seen,  the  (M/B)efwa  variable  becomes  more  significant  as  time  passes,  and   turns  into  the  most  significant  one  in  the  IPO+10  sample.  Compared  to  the  result  of  all   firms  in  the  10  years,  this  result  shows  the  gradual  progress  and  proves  the  continuous   effect  of  historical  market  timing  attempts.     The   interesting   thing   is   that   after   the   introduction   of   (M/B)efwa   ,   (M/B)t-­1   becomes   less   significant  when  data  is  observed  by  independent  IPO  subsamples.  (M/B)t-­1  only  passes   the  significance  test  in  the  IPO+1  sample.  At  the  end  of  year  10,  the  coefficient  of  (M/B)t-­ 1  becomes  positive,  which  is  the  same  in  the  study  of  Baker  &  Wurgler  (2002).  Hence,  the   result   explains   why   when   the   data   is   observed   in   a   continuous   process,   the   external   finance   weighted-­average   market-­to-­book   value   performs   better   than   normal   lagged   market-­to-­book  value.     Like  all  the  results  before,  the  presence  strong  tangibility  is  always  a  stable  support  for  a   firm   to   debt.   The   positive   correlation   has   been   proven   in   all   models.   Similarly,   the   coefficient  for  profitability  is  always  inverse  to  that  of  tangibility,  and  profitability  is  always   negatively   correlated   with   leverage.   Nevertheless,   the   importance   of   firm   size   in   the   financing  structure  is  diminishing  as  time  passes.  In  the  IPO+10  sample,  firm  size  is  not   a  significant  variable,  which  indicates  that  the  scale  of  firms  does  not  matter  that  much  in   the  long  run.  Like  the  principle  of  diminishing  rate  of  return,  initially,  larger  scale  can   diversify  a  firm’s  risk  and  stabilize  their  profitability.  However,  in  the  long  run,  when  their   competitors  reach  a  similar  level  of  scale  and  the  market  is  quite  stable,  the  advantages   that  large  size  once  brought  will  vanish.   To  summarize,  if  data  is  being  studied  in  a  cross-­sectional  manner,  market-­to-­book  value   is  significant  and  indicates  that  periodical  adjustments  of  managers  affect  capital  structure.   However,   if   the   data   is   analysed   across   time,   in   the   long-­term,   the   external   finance   weighted-­average   market-­to-­book   value   is   more   powerful,   because   the   effect   is   cumulative,  and  becomes  more  significant  with  time.  No  matter  which  method  is  used  in   which   model,   the   external   finance   weighted-­average   market-­to-­book   value   is   always   significant.  Thus,  hypothesis  3  cannot  be  rejected,  and  a  conclusion  can  be  drawn  that   market  timing  does  have  a  persistent  effect  on  capital  structure  that  may  last  for  about   ten  years.  
39 6.  Conclusion     6.1  Limitations       In  sum,  this  dissertation  has  significant  results  and  answers  the  three  questions  listed  in   the  section  outlining  our  objectives.  However,  many  limitations  still  exist  and  may  have   an  adverse  influence  on  the  accuracy  of  the  research.   First  of  all,  the  data  is  ranges  from  2005-­2015.  Due  to  the  financial  crisis  of  2008-­09,  many   listed  companies  have  abnormal  values  of  book  leverage  and  especially  market  leverage,   and  even  lack  of  data.  In  order  to  avoid  the  bias  of  extreme  values,  conditions  have  been   applied   when   selecting   the   companies.   For   instance,   like   stated   in   the   methodology,   companies  with  market  to  book  value  exceeding  10,  and  with  book  leverage  below  0  or   over  1  are  all  removed  from  the  sample.  Those  restrictions  aid  to  remove  the  influence  of   the  crisis  to  a  relatively  large  extent,  but  it  leads  to  the  shrinkage  in  sample  size  as  well.   Data  of  many  companies  have  been  deleted  because  either  one  of  the  or  both  of  the   variables  cannot  meet  these  requirements.  The  IPO  sample  in  2008  only  contains  6  listed   companies  and  their  IPOs.  In  the  analysis  of  Model  3,  the  subsample  IPO+10  is  actually   a  combined  one  of  subsample  IPO+9  and  IPO+10,  because  IPO+10  only  includes  26   listed  companies,  which  is  below  the  minimum  sample  size  of  30,  and  cannot  be  tested   as  a  normal  distribution.     Secondly,  similar  to  research  done  by  Baker  &  Wurgler  (2002),  this  dissertation  did  not   manage  to  distinguish  between  the  effects  of  market  timing  from  perceived  mispricing  or   adverse  selection.  More  data  and  models  are  required  to  do  precise  tests  for  these  two   types  of  market  timing.  It  can  be  conducted  by  following  the  example  of  Chazi  (2004),   where  he  quantifies  the  perceived  mispricing  and  adverse  selection  by  using  net  insider   trading  and  checks  the  relationship  between  net  insider  trading  and  leverage.  Additionally,   he  adds  different  dummy  variables  for  the  two  types  of  market  timing.      
40 6.2  Summary   This   dissertation   aims   to   study   the   relationship   between   market   timing   and   capital   structure  in  Hong  Kong.  This  dissertation  proves  the  existence  and  long-­lasting  effects  of   market  timing  behaviour  on  changes  in  capital  structure  in  Hong  Kong  listed  companies   from  2005  to  2015.  The  main  contribution  is  providing  evidence  from  an  area  that  few   people  have  studied  before,  which  is  Hong  Kong,  and  the  use  of  a  new  time  period.  The   result  is  consistent  with  the  majority  of  literature  based  on  developed  markets.   It  turns  out  that  market  timing  behaviour  universally  exists  in  Hong  Kong  listed  companies,   from  both  the  equity  and  debt  financing  perspectives.  Firms  tend  to  issue  IPOs  when  their   market  value  is  high,  and  choose  debt  otherwise.  In  the  short  run,  capital  structure  can   be  affected  by  market  timing  behaviour,  but  it  will  be  influenced  by  the  firm’s  tangibility   and  profitability  to  a  greater  degree.  In  the  long  run,  market  timing  actions  have  persistent   effects.  At  each  time  period,  firms  rebalancing  to  the  movement  of  equity  markets  is  vital.   The  accumulated  timing  behaviour  has  a  greater  importance  as  time  passes.  This  result   can  be  considered  as  evidence  of  the  application  of  market  timing  in  Hong  Kong.                    
41 Appendices     Figure  1  Static  Trade-­off  Theory   The  graph  above  is  referred  from  Robichek  &  Myers  (1966).  The  graph  shows  the  dual   characteristics  of  debt.  On  the  one  hand,  debt  increases  the  firm  value  and  lets  the  firm   benefit  from  tax  shields.  On  the  other  hand,  debt  potentially  inflicts  upon  firm’s  higher   bankruptcy  costs  and  agency  costs.     Figure  2  Trade-­off  Model  Based  on  Agency  Cost  
42 The  graph  above  is  referred  from  Myers  &  Majluf  (1984).  It  explains  that  in  the  process  of   reaching  the  optimal  capital  structure,  a  firm  always  faces  the  problem  of  agency  cost  no   matter  whether  the  firm  chooses  debt  financing  or  equity  financing.     Table  1  Sources  of  Net  Capitals  in  Developed  Countries   The  table  above  uses  data  from  Corbett  &  Jenkinson  (1996).  It  proves  the  pecking  order   theory   by   providing   evidence   from   several   developed   countries.   The   data   shows   that   these  countries  consider  internal  finance  as  their  absolute  first  choice.      
43 References   Adrian,  T.,  Etula,  E.,  &  Shin,  H.  S.  (2015).  Risk  appetite  and  exchange  rates.   Akerlof,   G.   (1970).   The   market   for   lemons:   qualitative   uncertainlyand   market   mechanism.  Quarterly  Journal  of  Economics,  89.   Alti,  A.  (2006).  How  persistent  is  the  impact  of  market  timing  on  capital  structure?  The   Journal  of  Finance,  61(4),  1681-­1710.   Asquith,  P.,  &  Mullins,  D.  W.  (1986).  Equity  issues  and  offering  dilution.Journal  of  financial   economics,  15(1),  61-­89.   Baker,  M.,  Stein,  J.  C.,  &  Wurgler,  J.  (2002).  When  does  the  market  matter?  Stock  prices   and   the   investment   of   equity-­dependent   firms  (No.   w8750).   National   Bureau   of   Economic  Research.   Baker,   M.,   &   Wurgler,   J.   (2002).   Market   timing   and   capital   structure.  The   journal   of   finance,  57(1),  1-­32.   Beck,  T.,  Demirguc-­‐Kunt,  A.,  Laeven,  L.,  &  Levine,  R.  (2008).  Finance,  firm  size,  and   growth.  Journal  of  Money,  Credit  and  Banking,  40(7),  1379-­1405.   Brealey,  R.,  Leland,  H.  E.,  &  Pyle,  D.  H.  (1977).  Informational  asymmetries,  financial   structure,  and  financial  intermediation.  The  journal  of  Finance,32(2),  371-­387.   Chazi,   A.   (2004).   Which   version   of   the   equity   market   timing   affects   capital   structure,   perceived  mispricing  or  adverse  selection?.   Chazi,  A.,  &  Tripathy,  N.  (2007).  Which  version  of  equity  market  timing  affects  capital   structure?.  Journal  of  applied  finance,  17(1),  70.   Corbett,  J.,  &  Jenkinson,  T.  (1996).  The  financing  of  industry,  1970–1989:  an  international   comparison.  Journal  of  the  Japanese  and  international  economies,  10(1),  71-­96.   Fama,  E.  F.,  &  French,  K.  R.  (2000).  Forecasting  Profitability  and  Earnings*.The  Journal   of  Business,  73(2),  161-­175.  
44 Fischer,  E.  O.,  Heinkel,  R.,  &  Zechner,  J.  (1989).  Dynamic  capital  structure  choice:  Theory   and  tests.  The  Journal  of  Finance,  44(1),  19-­40.   Flannery,   M.   J.,   &   Rangan,   K.   P.   (2006).   Partial   adjustment   toward   target   capital   structures.  Journal  of  financial  economics,  79(3),  469-­506.   Graham,   J.,   &   Harvey,   C.   (2002).   How   do   CFOs   make   capital   budgeting   and   capital   structure  decisions?.  Journal  of  applied  corporate  finance,  15(1),  8-­23.   Harris,   M.,   &   Raviv,   A.   (1991).   The   theory   of   capital   structure.  the   Journal   of   Finance,  46(1),  297-­355.   Hermanns,  J.  (2007).  Optimale  Kapitalstruktur  und  Market  Timing:  Empirische  Analyse   börsennotierter  deutscher  Unternehmen.  Springer-­Verlag.   Hovakimian,   A.   (2004).   The   role   of   target   leverage   in   security   issues   and   repurchases.  The  Journal  of  Business,  77(4),  1041-­1072.   Hovakimian,   A.   (2006).   Are   observed   capital   structures   determined   by   equity   market   timing?.  Journal  of  Financial  and  Quantitative  analysis,  41(01),  221-­243.   Hovakimian,  A.,  Hovakimian,  G.,  &  Tehranian,  H.  (2004).  Determinants  of  target  capital   structure:   The   case   of   dual   debt   and   equity   issues.  Journal   of   financial   economics,  71(3),  517-­540.   Huang,  R.,  &  Ritter,  J.  R.  (2009).  Testing  theories  of  capital  structure  and  estimating  the   speed  of  adjustment.  Journal  of  Financial  and  Quantitative  analysis,  44(02),  237-­ 271.   Jensen,  M.  C.,  &  Meckling,  W.  H.  (1976).  Theory  of  the  firm:  Managerial  behavior,  agency   costs  and  ownership  structure.  Journal  of  financial  economics,  3(4),  305-­360.   Jenter,   D.   (2005).   Market   timing   and   managerial   portfolio   decisions.  The   Journal   of   Finance,  60(4),  1903-­1949.  
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Market Timing and Capital Structure Evidence from Hong Kong Listed Companies

  • 1.       Market  Timing  and  Capital  Structure:   Evidence  from  Hong  Kong  Listed  Companies     Submitted  by  Feifei  Wang  to  the  University  of  Exeter     as  a  dissertation  towards  the  degree  of  Master  of  Science  (MSc)   in  Financial  Analysis  and  Fund  Management     August  2016     Supervisor:  Dr  Pedro  Angel  Garcia  Ares     I  certify  that  all  material  in  this  dissertation  which  is  not  my  own  work  has  been  identified  and   that  no  material  is  included  for  which  a  degree  has  previously  been  conferred  upon  me     Signature…………………………………………………………....      
  • 2. 2 Abstract       Capital  structure  is  always  a  keyword  associated  with  modern  corporate  finance.  Market   timing  theory  is  a  popular  strand  among  theories  about  capital  structure.  This  dissertation   uses  IPO  data  from  227  Hong  Kong  listed  companies  from  2005  to  2015.  I  hope  to  provide   a  refreshing  view,  as  little  prior  research  focuses  on  the  Hong  Kong  market,  and  the   majority  of  past  literature  apply  data  available  no  later  than  2003.  The  main  methodology   is  linear  regression  and  I  apply  three  different  models  to  test  the  existence  of  short-­term   and  long-­term  effects  of  market  timing  respectively.  The  results  confirm  that  1)  market   timing  actions  exist  in  both  in  debt  financing  and  equity  financing  decisions  of  Hong  Kong   listed  companies  2)  short-­term  effects  of  market  timing  on  capital  structure  exist  and  3)   persistent  effects  of  market  timing  behaviour  on  capital  structure  that  can  last  for  10  years   exist.  This  dissertation  provides  evidence  to  support  the  market  timing  theory  in  Hong   Kong   listed   companies.   The   result   is   consistent   with   the   majority   of   studies   based   in   developed  economies.      
  • 3. 3 TABLE  OF  CONTENTS   ACKNOWLEDGEMENTS  .............................................................................................................  5   1.  INTRODUCTION  .......................................................................................................................  6   1.1  PROBLEM  DEFINITION  ...........................................................................................................  6   1.2  OBJECTIVE  STATEMENT  ........................................................................................................  8   1.3  STRUCTURE  OF  THIS  DISSERTATION  ......................................................................................  8   2.  LITERATURE  REVIEW  ............................................................................................................  9   2.1  TRADE-­OFF  THEORY  ..............................................................................................................  9   2.1.1  Static  trade-­off  theory  ...................................................................................................  9   2.1.2  Dynamic  trade-­off  theory  ............................................................................................  10   2.2  PECKING  ORDER  THEORY  ....................................................................................................  11   2.3  THEORY  BASED  ON  AGENCY  COSTS  .....................................................................................  11   2.3.1  Managerial  entrenchment  theory  ...............................................................................  12   2.4  MARKET  TIMING  THEORY  .....................................................................................................  13   2.4.1  Windows  of  opportunity  hypothesis  ............................................................................  13   2.4.2  Perceived  mispricing  ..................................................................................................  14   2.4.3  Adverse  selection  .......................................................................................................  15   3.  METHODOLOGY  ....................................................................................................................  18   3.1  VARIABLE  DEFINITION  .........................................................................................................  18   3.1.1  Market  timing  indicator  ...............................................................................................  18   3.1.2  Capital  structure  and  determinants  ............................................................................  20   3.2  HYPOTHESIS  AND  MODELS  ..................................................................................................  23   3.2.1  Hypothesis  1  Existence  of  Market  timing  ...................................................................  24   3.2.2  Hypothesis  2:  Short-­term  effect  ..................................................................................  25   3.2.3  Hypothesis  3:  Persistent  effect  ...................................................................................  26   4.  DATA  ......................................................................................................................................  28   5.  RESULTS  AND  ANALYSIS  ....................................................................................................  30   5.1  EXISTENCE  OF  MARKET  TIMING  BEHAVIOUR  ..........................................................................  30   5.2  SHORT-­TERM  EFFECTS  OF  MARKET  TIMING  BEHAVIOUR  ........................................................  34   5.3  PERSISTENT  EFFECT  OF  MARKET  TIMING  BEHAVIOUR  ............................................................  36   6.  CONCLUSION  ........................................................................................................................  39   6.1  LIMITATIONS  .......................................................................................................................  39   6.2  SUMMARY  ...........................................................................................................................  40   APPENDICES  .............................................................................................................................  41   REFERENCES  ............................................................................................................................  43    
  • 4. 4 LIST  OF  TABLES   Table  1  Various  Equity  Choices  under  “Windows  of  Opportunity”  ……………..………..14   Table  2  Summary  of  Capital  Structure  Theories…………………………………………...17   Table  3  Summary  of  Different  Choices  on  Market-­timing  Indicators……………..………19   Table  4  Summary  of  Variable  Definitions   ………………………………………………..23   Table  5  Summarised  Statistics  of  Capital  Structure  and  Financing  Decisions.………...30   Table  6  Pearson  Correlation  between  Variables…………………………………………...32   Table  7  Coefficients  of  Model  1a  ...………………………………………………………….33   Table  8  Coefficients  of  Model  1b&1c  ...……………………………………………………..33   Table  9  Coefficients  of  Model  2a  …………………………………………………………....34   Table  10  Coefficients  of  Model  2b…………………………………………………………...35   Table  11  Coefficients  of  Model  3a…………………………………………………………...36   Table  12  Summary  of  Subsamples  Coefficients  …………………………………………..37      
  • 5. 5 Acknowledgements     I  would  like  to  express  sincere  appreciation  to  my  supervisor  Dr  Pedro  Angel  Garcia  Ares   for  his  constant  guidance  and  support.  He  always  encouraged  me  to  explore  the  field  I   was  interested  in  and  provided  thorough  advice  on  my  work.  His  suggestions  helped  me   understand  how  to  conduct  and  organise  a  professional  dissertation  and  help  me  get  to   where  I  am  today.   I  would  like  to  convey  my  heartfelt  thanks  to  Dr  Angela  Christidis,  who  is  the  module   coordinator  for  finance  dissertation,  for  her  help  to  me  and  her  efforts  to  this  dissertation.   I  would  also  like  to  present  my  honest  gratitude  to  Eugene  for  all  the  inspirations  from   those  interesting  discussions  with  you.  I  don’t  know  where  I’d  be  without  you.   Last,  but  definitely  not  the  least,  I  would  like  to  thank  my  parents  and  my  whole  family,  for   accompanying  me  through  tough  days  with  your  encouragement  and  belief  in  me.  I  will   always  remember  your  eternal  love,  in  those  times  when  I  need  them  the  most.      
  • 6. 6 1.  Introduction     Capital  structure  must  not  be  a  strange  word  to  most  of  people  as  it  is  vital  to  corporate   finance.  After  Modigliani  and  Miller  published  their  study  about  capital  structure  in  1958,   it  has  become  a  popular  topic  and  many  researchers  have  made  their  contribution  to  the   field.  In  general,  capital  structure  is  a  mix  of  sources  for  firms  to  raise  capital,  and  normally   it  is  comprised  of  debt  and  equity.  Firms  make  so  much  effort  to  allocate  debt  and  equity   in  an  appropriate  way  in  order  to  maximise  firm  value  and  shareholder  interest.   There  are  mainly  two  traditional  theories  about  capital  structure:  One  is  trade-­off  theory,   and  the  other  is  pecking  order  theory.  These  two  theories  form  the  fundamentals  for  other   theories.  However,  traditional  trade-­off  theory  assumes  the  existence  of  an  optimal  capital   structure,  and  pecking  order  theory  requires  an  absolute  order  of  financing.  Thus,  both  of   them  do  not  seem  to  fit  the  flexible  financial  environment  that  exists  nowadays.  This  is   what   makes   the   appearance   of   the   “market   timing”   concept   so   important.   It   was   first   introduced  in  Baker  &  Wurgler  (2002),  where  they  describe  the  theory  as  “capital  structure   is  the  cumulative  outcome  of  attempts  to  time  the  equity  market”.  Market  timing  theory   absorbs   concepts   from   previous   theories   and   develops   upon   them,   but   it   does   not   necessarily   need   any   assumptions,   unlike   trade-­off   theory   or   pecking   order   theory.   It   adapts  to  the  new  pattern  of  corporate  finance  where  firms  pay  more  attention  to  market   situations  than  previous  years  when  they  are  making  financial  decisions,  which  makes   the  new  theory  valuable  and  worth  studying.     1.1     Problem  Definition     Whether   market   timing   behaviour   exists;;   whether   it   will   bring   significant   influence   to   capital  structure;;  does  the  effect  exist  in  the  short  or  long  run  time  horizons,  and  does  it   only  apply  to  developed  markets?  Many  questions  remain  unanswered.   The  first  controversial  issue  is  whether  the  market  timing  behaviour  examined  in  the  study   of  Baker  &  Wurgler  (2002)  really  exists.  In  their  paper,  market  timing  is  a  behaviour  in   which  firms  adopt  different  actions  according  to  market  situations  when  making  financing   decisions.  To  be  more  specific,  firms  issue  equity  when  they  think  the  market  is  booming,  
  • 7. 7 and  thus  their  stocks  tend  to  be  overvalued.  In  contrast,  firms  will  repurchase  those  stocks   when  the  market  is  relatively  depressed.  Hence,  in  Model  1  of  this  dissertation,  equity   financing  and  debt  financing  are  applied  as  two  dependent  variables,  the  market  to  book   value  is  the  independent  variable,  and  this  paper  aims  to  test  the  relationship  between   them.  If  the  market  timing  theory  holds,  there  should  be  an  inverse  relationship  between   market  to  book  value  and  debt,  while  a  positive  relationship  between  that  and  equity   issued.  Results  from  Model  1  confirm  both  debt  timing  and  equity  timing  of  Hong  Kong   listed  companies.   Aside  from  the  question  on  the  theory’s  existence,  another  problem  is  the  geographical   application  of  this  theory.  Since  the  study  of  Baker  &  Wurgler  (2002),  their  empirical  study   has   attracted   much   attention   as   plenty   of   scholars   have   devoted   themselves   into   the   investigation  of  the  new  theory.  Abundant  studies  have  proven  the  existence  and  effects   of  market  timing  behaviour  in  different  markets,  the  majority  of  which  use  information  from   American  listed  companies  and  their  IPOs.  Xu  (2009)  made  investigations  of  Canadian   companies  and  proves  the  influence  of  historical  IPOs  on  capital  structure.  Sautner  and   Spranger  (2009)  present  the  result  of  European  listed  companies  and  support  this  theory,   while  Hermanns  (2006)  supported  this  theory  by  result  of  an  empirical  study  in  Germany.   However,  the  relationship  seems  to  apply  only  for  firms  in  developed  markets.  Zhou  (2011)   made  a  thorough  study  in  China,  but  failed  to  prove  the  effects  both  in  the  short,  and  long,   runs.   Whether   market   timing   theory   only   applies   to   developed   markets   has   become   another  source  of  intrigue  to  researchers.     Finally,  many  researchers  are  also  concerned  about  whether  the  effect  of  market  timing   behaviour  lasts  in  the  short  run  or  long  run.  Baker  &  Wurgler  (2002)  shows  a  significant   short-­term  influence  and  a  persistent  effect  that  can  last  for  about  10  years.  Therefore,   this  dissertation  designs  Model  2  and  Model  3  to  test  the  short-­term  and  persistent  effects   respectively.  Model  2  uses  data  of  both  current  period  and  the  last  period  to  assess  the   consequence  of  periodical  change.  Model  3  introduces  the  variable  of  the  external  finance   weighted-­average  market-­to-­book  ratio  that  was  created  by  Baker  &  Wurgler  (2002)  to   represent  the  accumulated  historical  market  timing  behaviour  to  evaluate  their  effect  in   the  long  run.  
  • 8. 8 1.2  Objective  Statement     Briefly  speaking,  this  dissertation  aims  to  answer  3  questions  that  correspond  to  those  in   the  Problem  Statement  above:  1)  Whether  market  timing  behaviour  exists  in  Hong  Kong   listed  companies;;  2)  Whether  the  short-­term  effect  of  market  timing  behaviour  to  capital   structure  exists  in  Hong  Kong  listed  companies;;  and  3)  Whether  a  persistent  effect  exists   in  Hong  Kong  listed  companies.     As  mentioned  before,  researchers  have  found  evidence  in  different  developed  markets,   but  few  scholars  have  conducted  research  in  the  Hong  Kong  area.  Yiu  (2016)  reported  in   the  South  China  Morning  Post  that  Hong  Kong  has  surpassed  New  York  to  become  the   top  IPO  market  in  the  world.  Equity  market  timing  is  a  vital  element  in  IPO  issue,  thus  it   is  worth  studying  the  Hong  Kong  market.  Hong  Kong  is  a  developed  market  in  Asia,  but   its  special  relationship  with  mainland  China  makes  the  market  unique.  Many  studies  failed   to  find  evidence  on  effects  of  market  timing  in  China  market  as  it  is  an  emerging  market.   Whether  the  close  relationship  between  the  Hong  Kong  market  and  China  market  affects   the   result   is   one   of   the   questions   that   need   clarification.   In   addition,   the   majority   of   literature  referred  in  this  dissertation  apply  data  available  no  later  than  2003.  This  paper   uses  data  ranging  from  2005  to  2015,  which  is  quite  an  updated  period.  Thus,  one  of  my   objectives  is  to  test  whether  the  theory  still  stands  in  the  new  era  of  corporate  finance.   1.3     Structure  of  this  Dissertation     There  are  5  parts  to  this  dissertation:  1)  Introduction,  providing  background  information,   giving   the   problem   definition   and   expressing   the   objectives   of   this   dissertation   2)   Literature  Review,  providing  summary  of  related  literature,  classified  theories  into  various   categories   and   explaining   relationships   between   different   theories   3)   Methodology,   demonstrating  statistical  methods,  hypotheses  and  models.  Additionally,  it  also  contains   a   data   description   and   variable   definition   4)   Result   and   Analysis,   illustrating   detailed   results  with  various  tables,  and  presenting  thorough  analyses  of  results  5)  Conclusion,   outlining   limitations   and   summarising   this   dissertation.   The   remaining   parts   are   the   Abstract  at  the  beginning,  APA  style  references  and  an  Appendix  at  the  end.    
  • 9. 9 2.  Literature  review     I  introduce  various  theories  about  capital  structure  in  this  part  to  compare  reasons  behind   different   choices   for   different   companies.   The   objective   of   this   paper   is   to   study   the   relationship  between  capital  structure  and  market  timing  strategies,  and  therefore  the   market  timing  theory  is  emphasised  here.  The  publication  of  Modigliani  and  Miller  in  1958   can   be   considered   as   the   beginning   of   studies   on   capital   structure.   According   to   the   Modigliani-­Miller  theorem  (MM,  1958),  under  the  premise  of  efficient  markets  (that  the   market  is  free  of  arbitrage)  and  excluding  tax  issues,  bankruptcy  cost  and  asymmetric   information,  firm  value  is  not  related  with  the  amount  of  leverage,  or  how  the  company   raises   capital.   After   that,   the   amount   of   studies   and   literatures   increases   rapidly   and   several  strands  of  theories  are  formed.   2.1  Trade-­off  theory     The   most   important   assumption   of   the   Modigliani-­Miller   theorem   is   there   is   no   tax.   However,  for  modern  corporations,  this  assumption  cannot  stand  and  debt  seems  more   like  an  efficient  way  of  raising  capital,  because  the  interest  on  debt  may  be  tax  deductible.   Trade-­off  theory  developed  on  the  base  of  the  Modigliani-­Miller  theorem  in  1958  and  its   core  argument  is  that  capital  structure  has  influence  on  firm  value,  and  an  optimal  capital   structure  exists.  Theories  can  be  classified  into  two  categories:  “Static”  and  “Dynamic”.   2.1.1  Static  trade-­off  theory     Static  trade-­off  theory  can  be  viewed  as  an  improved  version  of  the  MM  model.  In  sum,   the  static  trade-­off  theory  takes  the  effects  of  both  taxation  and  bankruptcy  costs  into   account,  and  confirms  the  presence  of  the  optimal  capital  structure.   Firstly,   tax   issues   have   been   taken   into   consideration.   In   1963,   Modigliani   and   Miller   introduced  corporate  income  tax  into  the  original  MM  model.  According  to  Miller  (1977),   both  change  in  individual  income  tax  and  change  in  corporate  income  tax  have  influence   on  the  optimal  capital  structure.  To  be  more  specific,  facing  higher  corporate  income  tax   rates,  firms  will  prefer  acquiring  capital  from  debt  rather  than  issuing  equities,  due  to  the  
  • 10. 10 tax  shield.  Under  higher  individual  income  tax  rates,  and  when  the  tax  rate  of  dividend   income  is  lower  than  that  of  interests  of  issuing  debt,  firms  will  choose  to  raise  capital  by   issuing   shares.   Secondly,   the   bankruptcy   cost   is   incorporated   into   the   MM   model.   Modigliani  and  Miller  (1963)  drew  a  conclusion,  that  there  is  a  growth  in  firm  value  as  a   result  of  increased  debt-­to-­asset  ratios,  and  therefore  the  optimal  capital  structure  should   be   100%   liabilities.   However,   in   the   event   of   heavy   debt,   the   possibility   of   a   firm’s   bankruptcy  will  increase  significantly.  Once  bankruptcy  happens,  various  expenses  will   follow.   Hence,   firm   should   realise   that   though   debt   brings   a   firm   benefit   from   tax   deductions,   it   also   delivers   risks   of   collapse.   Figure   1   in   appendices   provides   the   illustration  of  the  static  trade-­off  theory.   2.1.2  Dynamic  trade-­off  theory     Dynamic  trade-­off  theory  holds  the  assumption  of  semi-­strong  market  efficiency,  and  that   managers  make  financing  decision  for  the  maximisation  of  firm  value.  Compared  to  the   static   theory,   the   dynamic   version   further   illustrates   the   relationship   between   capital   structure  and  different  costs  during  a  firm’s  process  of  adjustment.     Stiglitz  (1973)  was  the  pioneer  of  the  dynamic  trade-­off  theory.  He  built  the  fundamentals   of  this  theory  based  on  the  tax  shield  benefit  and  bankruptcy  cost.  Myers  (1984)  proposed   the  idea  in  static  trade-­off  theory  that  a  firm  will  set  a  goal  of  optimizing  capital  structure,   and  thought  the  dynamic  trade-­off  theory  is  about  how  firms  adapt  their  capital  structure   towards  the  targeted  one  step  by  step  after  events.  Fischer,  Heinkel  and  Zechner  (1989)   introduced   the   concept   of   adjustment   cost   into   the   theory.   If   adjustment   cost   is   acknowledged,  there  will  always  be  differences  between  the  actual  capital  structure  and   the  optimal  one  that  a  firm  wants  to  reach,  and  the  speed  of  adaptation  is  determined  by   the  cost  of  alteration.  The  presence  of  adjustment  cost  constraining  a  company’s  capital   structure  fluctuates  within  a  certain  range,  and  only  when  the  gap  between  actual  capital   structure  and  the  target  one  is  relatively  large,  will  the  firm  make  adjustments  to  their   capital  structure.  
  • 11. 11 2.2  Pecking  order  theory     Compared  to  trade-­off  theory,  the  pecking  order  theory  does  not  necessarily  require  the   existence   of   an   optimal   capital   structure   and   it   believes   financial   leverage   is   an   accumulated  result  of  historical  capital  raising  activities.   The  pecking  order  theory  was  first  proposed  by  Myers  (1984).  The  theory  illustrates  the   priority   of   methods   in   raising   funds   under   the   effects   of   adverse   selection   due   to   information  asymmetry.  Given  several  ways  a  firm  can  choose  to  finance  its  activities,   firms  tend  to  pick  internal  financing  as  their  first  choice,  followed  by  debt  financing,  and   equity  financing  will  be  the  last  resort.  Myers  (1984)  stated  that  if  the  firm  accumulates   enough  retained  earnings,  they  would  not  have  to  bear  the  risk  of  issuing  common  stock,   which  is  a  relatively  riskier  way  for  raising  funds.  Therefore,  firms  tend  have  requirements   on  their  payout  ratio  to  make  sure  certain  degrees  of  investment  can  be  satisfied  simply   by  internal  financing.  According  to  the  latest  research  on  this  theory,  pecking  order  theory   cannot  generally  apply  to  all  enterprises.  Different  orders  are  described  in  financing  of   firms   in   emerging   markets   and   developed   market.   Firms   in   developed   countries   like   American  corporations  tend  to  perfectly  follow  “pecking  order  theory”.  They  initially  rely   on  internal  funds,  then  seek  external  financing  sources  like  debt  issues  or  equity  financing.   But  in  the  case  of  Chinese  firms,  the  proportion  of  external  financing  is  bigger  than  internal   financing,  and  equity  financing  is  the  most  preferred  method  (Zhou,  2011).  Table  1  in   appendices   proves   the   pecking   order   theory   by   providing   evidence   from   several   developed  countries.   2.3  Theory  based  on  agency  costs     Agency  cost  comes  down  to  the  separation  of  ownership  and  management.  When  firms   hire  managers  to  run  the  organisation  on  their  behalf,  a  gap  emerges  because  these  two   groups   have   conflicts   of   interests   and   managers   own   the   comparative   advantage   of   information.     Jensen  and  Meckling  (1976)  emphasises  the  existence  and  importance  of  agency  costs   in  their  paper,  and  classify  the  models  based  on  agency  costs  into  two  categories.  The  
  • 12. 12 first  conflict  exists  between  managers  and  equity  holders.  In  order  to  test  the  action  of   managers,  they  divided  equity  into  two  parts  -­-­-­  inside  and  outside,  based  on  whether  the   equity  is  held  and  used  by  the  managers.  Inside  equity  is  the  part  that  is  accessible  for   managers   and   vice   versa.   It   turns   out   that   managers   tend   to   use   resources   and   information  held  for  their  own  benefit,  which  is  normally  against  the  interests  of  equity   holders.  In  a  word,  agency  cost  arises  due  to  the  conflicts  between  a  manager’s  behaviour   and  an  equity  owner’s  benefit.  The  second  conflict  arises  from  the  conflict  between  firm’s   equity   holders   and   its   debt   holders.   Provided   that   equity   holders   make   a   high-­risk   investment,  which  may  provide  them  with  high  yield  of  return  on  the  condition  that  it  is   successful.  However,  under  the  circumstance  of  failure,  debt  owners  suffer  from  loss  of   interest  or  even  principal.  Thus,  equity  holders  have  the  motivation  to  choose  investments   with  extra  risk,  which  can  be  a  hazard  to  debt  holders  due  to  the  higher  default  possibility.   The   idea   that   equity   owners   use   risky   investment   to   transfer   risk   and   liability   to   debt   owners  is  called  the  “asset  substitution  effect”  or  “risk-­shifting  hypothesis”.  Figure  2  in   appendices  explains  firm’s  process  of  reaching  the  optimal  capital  structure.   2.3.1  Managerial  entrenchment  theory       Managerial  entrenchment  theory  emphasises  that  managers  value  their  own  position  or   ventures  more  than  the  optimum  capital  structure  and  interests  of  shareholders.  Novaes   and  Zingales  (1995)  believe  that  managers  and  shareholders  hold  different  views  towards   debt.  Stakeholders  of  firms  tend  to  consider  debt  as  a  tool  of  efficiency  maximisation.   Nonetheless,  managers,  who  are  actually  making  the  business  decisions,  regard  debt  as   a  defensive  mechanism.  Zwiebel  (1996)  started  by  simply  discussing  the  advantages  and   disadvantages  of  managers’  accessibility  to  funds.  He  also  states  that  when  firms  are   highly  valued,  managers  tend  to  avoid  debt  and  do  not  rebalance  the  capital  structure   with  debt  for  personal  interest.  Managers  generally  face  two  major  threats:  bankruptcies   and  takeovers.  Debts  may  lead  to  bankruptcy;;  and  thus,  managers  avoid  accumulating   debt  for  their  own  benefit.  In  order  to  strengthen  individual  entrenchment,  managers  will   make  different  decisions  on  capital  structure.    
  • 13. 13 2.4  Market  timing  theory     Stein  (1996)  was  the  first  one  to  propose  the  idea  of  a  “market  timing  hypothesis”.  The   hypothesis  states  that  the  stock  market  is  irrational,  and  that  price  cannot  precisely  reflect   the  intrinsic  value  of  stocks.  When  a  firm’s  stock  price  is  overestimated,  rational  managers   are  supposed  to  issue  more  shares  to  take  full  advantage  of  investor  overenthusiasm.  On   the  contrary,  when  a  firm’s  stock  price  is  underestimated,  a  strategy  of  share  repurchasing   should  be  adopted  by  the  managers.     Baker  and  Wurgler  (2002)  also  raised  a  new  theory  about  capital  structure,  called  the   market  timing  theory.  They  describe  the  relationship  between  the  capital  structure  and   market  timing  as  “capital  structure  is  the  cumulative  outcome  of  attempts  to  time  the  equity   market”.  Their  concept  can  be  viewed  as  a  breakthrough  in  this  field  because  it  does  not   necessarily  require  the  hypothesis  of  rational  investors  and  perfect  arbitrage  as  does  the   traditional  theory  of  capital  structure.     2.4.1  Windows  of  opportunity  hypothesis     To  further  discuss  market-­timing  theory,  it  should  start  with  the  “windows  of  opportunity”   hypothesis  since  Baker  and  Wurgler’s  concept  is  based  on  the  empirical  studies  of  this   hypothesis.  Windows  of  opportunity  describes  the  existence  of  a  best  period  of  time  to   capitalise  on  events.  In  particular,  the  issue  of  the  initial  public  offering  (IPO)  is  a  case  of   windows   of   opportunity.   For   some   stocks   with   high   potential   such   as   Apple   Inc.,   the   window  of  opportunity  is  small  during  the  IPO  times  because  the  stock  price  will  increase   rapidly  later.  A  window  of  opportunity  is  also  associated  with  market  mispricing,  which   can   be   rectified   by   traders   after   they   realise   it.   In   short,   the   window   of   opportunity   hypothesis  indicates  that  the  time  of  IPO  issue  is  vital  for  the  future  development  of  a  firm,   and  how  well  managers  can  seise  the  short  period  of  opportunity  decide  the  amount  of   value  the  managers  can  create  for  shareholders.    
  • 14. 14   Table  1  Various  Equity  Choices  under  “Windows  of  Opportunity”   Table  1  is  referred  from  the  article  “The  long-­‐run  performance  of  initial  public  offerings”  of   Ritter  (1991),  the  research  found  that  the  under-­pricing  of  IPOs  is  normal,  but  it  exists   only  in  the  short  term.  In  the  long  term,  these  IPOs  underperform.  People  tend  to  become   over-­confident   about   the   future   returns   of   these   new   stocks   and   firms   fully   utilise   the   “window  of  opportunity”.  In  practice,  firms  choose  to  go  public  whenever  they  think  firm’s   stocks  are  overpriced.  The  action  that  the  firm  try  to  obtain  benefits  from  the  mispricing   can  be  considered  as  an  attempt  in  equity  market  timing.  In  particular,  he  illustrated  the   situation   by   listing   various   financing   orders   a   firm   tends   to   choose   under   different   circumstances.   Baker  and  Wurgler  (2002)  considered  two  types  of  equity  market  timing:  One  is  perceived   mispricing,  and  the  other  one  is  adverse  selection.     2.4.2  Perceived  mispricing     The   premise   of   this   section   is   that   managers   or   investors   are   irrational.   From   the   perspective   of   investors,   their   enthusiasm   will   drive   the   stock   price   higher   and   consequently  lead  to  overvalued  stocks.  Similarly,  investors’  depressed  emotions  may  be   the   impetus   for   declining   stock   prices   and   results   in   undervalued   stocks.   From   the   perspective   of   managers,   they   tend   to   issue   equity   if   they   consider   that   the   cost   is   relatively  low  and  repurchase  shares  if  they  believe  that  the  cost  is  relatively  high  (Chazi,   2004).  In  sum,  the  irrational  behaviours  of  both  investors  and  managers  lead  to  time-­ varying  mispricing.  Jenter  (2005)  supported  this  point  of  view  and  stated  that  managers   make  equity  decisions  based  solely  on  their  perceived  mispricing,  instead  of  a  real  need  
  • 15. 15 for  capital.  Under  this  situation,  if  a  firm  does  not  achieve  its  optimal  capital  structure,  and   managers   do   not   adjust   them   later,   the   temporary   change   in   stock   price   will   have   a   persistent  influence  on  capital  structure.     2.4.3  Adverse  selection     Adverse   selection   is   essentially   caused   by   asymmetric   information.   The   problem   of   information   asymmetry   is   common   in   the   business   world,   and   it   was   first   studied   by   George  Akerlof,  who  was  the  winner  of  2001  Economic  Nobel  Prize.  According  to  Akerlof   (1970),  due  to  the  presence  of  asymmetric  information,  buyer  and  seller  tend  to  hold   different   perceived   value   of   the   same   good,   and   the   difference   results   in   the   undervaluation  of  goods  with  premium  quality.  Finally,  inferior  goods  are  left  and  traded   on  the  market  instead  of  those  with  high  quality.     Ross  (1977),  Brealey,  Leland  and  Pyle  (1977)  stated  that  if  managers  make  decisions  on   capital   structure   based   on   inside   information,   the   choice   will   signal   information   to   outsiders  in  the  market,  and  this  theory  is  called  Signaling.  Myers  and  Majluf  (1984)  wrote   that   managers   of   the   firm   are   supposed   to   know   more   about   their   investment   than   investors,  which  can  cause  mispricing  in  the  market.  To  be  more  specific,  since  outside   investors  do  not  have  access  to  inside  information,  they  will  evaluate  a  firm  in  a  relatively   objective  way  with  a  mean-­reverting  value.  However,  managers  acquire  more  information.   When  they  face  favourable  news,  managers  will  avoid  issuing  equity  because  they  know   shares  are  underestimated.  Contrastingly,  when  they  receive  bad  news,  they  will  issue   equity  because  stocks  are  overvalued  at  this  time  compared  to  the  estimation  of  outsiders.   Once  they  make  the  issue  choices,  the  action  will  signal  information  to  outsiders,  and  thus   the  price  of  stock  will  drop  significantly  after  issue.   Baker  and  Wurgler  (2002)  drew  several  conclusions  in  their  paper:  1)  Equity  market  timing   indeed   affects   capital   structure   as   leverage   has   significant   negative   correlation   with   weighted  average  historical  market  value.  In  their  empirical  study,  they  broke  the  change   in  leverage  into  three  parts,  which  are  change  in  net  equity  issue  (e/A),  newly  retained   earnings  (∆RE/A)  and  the  net  debt  issue  as  the  residual  change  in  assets  (∆A/A-­∆E/A-­ ∆RE/A).  The  results  show  that  the  effect  of  M/B  value  to  leverage  mainly  comes  from  new  
  • 16. 16 equity  issue,  and  higher  M/B  value  leads  to  higher  amounts  of  issued  equity.  2)  The  effect   of  market  timing  actions  to  leverage  is  persistent  as  the  weighted  average  market  value   have  more  than  ten  years  of  influence  on  capital  structure.  Though  Baker  and  Wurgler   (2002)  proposed  two  types  of  market  timing,  they  did  not  distinguish  them  from  each  other   in  their  results.     After  Baker  and  Wurgler,  scholars  have  done  further  investigations  in  this  field  and  have   found  more  evidence  to  prove  the  theory.  Hovakimian  et  al.,  (2004)  discovered  in  their   paper  that  the  market  to  book  ratio  and  stock  returns  have  significant  influence  on  the   timing  of  equity  issues.  The  timing  of  issuing  stocks  depends  on  market  conditions,  and   they  found  firms  tend  to  issue  new  shares  after  a  notable  increase  in  stock  price.  Similarly,   Asquith  and  Mullins  (1986)  found  that  a  certain  price  pattern  is  associated  with  equity   market  timing.  The  price  of  stocks  is  generally  high  and  overvalued  before  the  issues  of   IPO.  However,  the  issue  of  stock,  or  to  be  more  accurate,  the  announcement  of  issue,  is   often  followed  by  decline  in  share  prices.  Another  survey  made  by  Graham  and  Harvey   (2002)  further  confirm  the  existence  of  equity  market  timing  by  managers.  They  surveyed   about  4440  companies  and  received  responses  in  the  form  of  392  finished  surveys,  and   found   that   the   action   of   equity   market   timing   is   common   in   modern   corporations.   In   addition,  firms  are  reluctant  to  resort  to  equity  issuing  because  they  do  not  want  to  dilute   their  earning  per  share  (EPS)  and  they,  following  trade-­off  theory,  want  to  set  a  target   debt  ratio  and  try  to  achieve  a  target  capital  structure  in  operations.     Furthermore,  on  the  question  of  whether  equity  market  timing  will  bring  capital  structure   a  continuous  influence,  Baker  and  Wurgler  (2002)  reported  their  result  as  a  persistent   one,  which  can  last  about  ten  years.     Huang  and  Ritter  (2009)  prove  the  long  lasting   influence  of  market  timing  in  their  empirical  study.  They  found  that  companies  choose  the   method  of  raising  funds  by  selecting  the  one  with  lower  cost  and  follow  the  pecking  order   theory  about  the  priority  of  internal  or  external  financing.  However,  Alti  (2006)  stated  in   his   paper   that   equity   market   timing   indeed   performs   as   a   critical   determinant   for   firm   financing  in  the  short  term,  but  it  become  less  important  as  time  goes  by,  as  he  found  the   effect   of   market   timing   to   be   diminishing   in   the   long   term   and   eventually   vanish.   In   accordance  with  Alti  (2006),  and  Flannery  and  Rangan  (2006),  they  claimed  that  the  effect  
  • 17. 17 of  market-­timing  is  temporary  because  a  firm’s  debt-­equity  ratio  adapts  to  changes  rapidly,   and  corresponding  adjustments  will  make  it  always  be  consistent  with  their  target  ratio.       Table  2  Summary  of  Capital  Structure  Theories   Table  2  provides  a  summary  of  theories  about  capital  structure.  An  obvious  trend  can  be   observed  that  new  theories  do  not  assume  the  presence  of  an  optimal  capital  structure,   but  these  theories  all  take  asymmetric  information  into  consideration.  Market  timing  theory   absorbs  knowledge  from  previous  theories,  and  it  is  developed  based  on  the  windows  of   opportunity  hypothesis.  Thus,  market  timing  theory  is  a  quite  comprehensive  and  updated   one,  and  is  relevant  to  this  era.      
  • 18. 18 3.  Methodology     The  methodology  is  divided  into  two  sections.  The  first  one  is  variable  definition,  which   introduces  and  defines  variables  that  will  be  used  in  the  linear  regression.  The  second   part  includes  hypotheses  and  corresponding  regression  models.  In  particular,  it  provides   explanations  on  choosing  variables  in  each  model  and  the  reasons  behind  these  choices.   3.1  Variable  Definition     Following  the  method  of  Baker  and  Wurgler  (2002),  this  paper  focus  on  the  relationship   between   market   timing   and   capital   structure,   other   variables   will   be   held   as   control   variables.  Variables  can  be  classified  into  two  categories:  1)  Market  timing  indicators  and   2)  Determinants  of  capital  structure.   3.1.1  Market  timing  indicator     In  this  paper,  the  Market  to  book  value  (M/B)  t  is  chosen  as  the  indicator  of  market  timing   following  the  empirical  study  of  Baker  and  Wurgler  (2002).  Previous  literature  has  used   this  ratio  as  the  variable  to  represent  market  timing.  For  example,  Rajan  and  Zingales   (1995)   used   the   market-­to-­book   ratio,   and   as   expected,   the   ratio   has   a   negative   correlation  with  leverage.  In  addition,  Baker  and  Wurgler  (2002)  divided  the  leverage  into   three  parts,  and  found  that  the  market-­to-­book  value  has  significant  positive  correlation   with  the  equity  issues.  Market-­to-­book  ratio  here  is  defined  as  the  result  of  total  asset   minus  book  equity  and  plus  market  capitalisation  divided  by  total  assets.     However,  whether  the  Market-­to-­book  ratio  can  be  considered  as  a  precise  proxy  for   market  timing  behaviour  is  still  controversial.  Hovakimian  (2006)  studied  firms  in  America   and  cannot  find  a  direct  and  significant  influence  of  market-­to-­book  ratio  on  the  capital   structure.   Instead,   he   found   an   inverse   relationship   as   a   result   of   the   larger   growth   potentials,  which  means  firms  possess  more  opportunity  to  expand  by  issuing  more  equity.   Thus,  some  scholars  replace  market-­to-­book  ratio  with  other  variables  as  indicators  of   market   timing   behaviour.   For   instance,   by   dividing   months   into   hot   months   and   cold   months,  Alti  (2006)  built  the  dummy  variable  of  “HOT”,  if  firm  issue  IPO  in  hot  months,  the  
  • 19. 19 value  is  1  otherwise  it  will  be  0.  Chazi  and  Tripathy  (2007)  use  insider  trading  as  an   alternative  method.       Table  3  Summary  of  Different  Choices  on  Market-­timing  Indicators   In  the  article  “A  Test  of  the  Market  Timing  Theory  in  China-­-­-­econometric  evidence  from   the   Chinese   listed   companies”   of   Liu   and   Li   (2005),   theories   are   divided   into   three   categories.   Table   3   chooses   and   organises   only   theories   that   concern   the   appropriateness  of  using  M/B  as  an  indicator  of  market  timing.  Table  3  also  summarised   different  indicators  for  market  timing  and  listed  the  main  conclusion  of  these  empirical   studies.     When  testing  the  persistent  effect  of  the  market-­to-­book  ratio  on  capital  structure,  Baker   and  Wurgler  (2002)  introduced  a  modified  variable  (M/Befwa)  into  their  model.  
  • 20. 20   The  variable  shown  in  the  figure  is  the  external  finance  weighted-­average  market-­to-­book   ratio.  The  variable  is  initially  introduced  in  the  paper  “Market  timing  and  capital  structure”   by   Baker   and   Wurgler   (2002),   and   they   described   it   as   it   “summarizes   the   relevant   historical  variation  in  market  valuations”.  Their  results  show  that  if  firm  raise  capital  from   external   financing   when   their   stocks   are   overvalued,   the   external   finance   weighted-­ average  M/B  ratio  will  subsequently  provide  high  value  even  if  they  eventually  choose   debt  or  equity  issuing.  This  number  directly  reflects  external  financing  actions  of  a  firm,   and  thus  firms  who  use  external  capital  more  frequently  will  observe  higher  values.  They   believe  the  new  measurement  is  better  than  simply  adding  a  lagged  M/B  ratio  because  it   points  out  which  of  those  lags  are  most  relevant  in  a  precise  way.   They  do  not  allow  negative  value  of  this  variable  as  they  have  to  make  sure  they  are   averaged  results.  The  minimum  of  this  value  is  zero  and  it  represents  that  no  information   of  market  change  is  reflected  by  the  variable  in  that  year.  Most  importantly,  all  of  these   restrictions   are   applied   to   avoid   the   weighted   number   increasing   with   the   increase   in   external  capital  in  each  period,  as  the  number  is  supposed  to  show  the  effect  of  historical   market  valuation  and  should  not  be  correspond  with  time.   3.1.2  Capital  structure  and  determinants     Leverage  itself  will  be  presented  by  the  ratio  of  debt  and  assets,  and  both  book  and   market  leverage  will  be  tested.  Three  other  relevant  variables  first  applied  by  Rajan  and   Zingales   (1995),   which   is   also   referred   to   Baker   &   Wurgler   (2002),   are   profitability   (EBITDA/At),  firm  size  Log  (St)  and  assets  tangibility  (PPE/At).   Leverage   Leverage  is  the  most  straight-­forward  and  precise  indicator  for  a  firm’s  capital  structure.   This  paper  uses  the  ratio  of  debt  to  total  assets  (D/At)  to  represent  leverage.  Both  book  
  • 21. 21 leverage  and  market  leverage  are  taken  into  consideration  in  this  model.  Book  leverage   (D/At)  is  calculated  as  book  debt  (D)  divided  by  total  assets  (A)  and  market  leverage  (D/At)   m  is  calculated  as  book  debt  divided  by  the  result  of  total  assets  minus  book  equity  (Eb)   and  plus  the  market  capitalisation  (Em).   Profitability   According  to  pecking  order  theory,  profitability  has  a  negative  relationship  with  leverage   because   high   earnings   allow   firms   to   acquire   capital   internally.   Hence,   firms   do   not   necessarily  need  to  raise  capital  from  external  sources.  Baker  and  Wurgler  (2002)  proved   that  profitability’s  effect  on  leverage  is  mainly  from  retained  earnings,  and  the  net  effect   of  higher  profitability  is  leverage  reduction.  However,  as  stated  in  trade-­off  theory,  firms   with   stronger   profitability   also   bear   heavier   tax   burdens   as   a   result   of   higher   profit.   Therefore,   they   will   have   stronger   motivation   to   issue   debt,   which   provides   firms   the   opportunity   to   benefit   from   tax   shields.   Additionally,   higher   profitability   indicates   less   possibility  of  bankruptcy,  which  means  that  firms  with  higher  profitability  generally  have   lower  bankruptcy  costs.  Thus,  firms  tend  to  choose  relatively  high  levels  of  debt  as  the   method  of  financing.  Under  the  pecking  order  theory,  higher  profitability  means  firms  own   more  internal  capital,  and  thus  will  use  less  leverage.     Profitability  (EBITDA/At)  is  calculated  as  earnings  before  interest,  taxes,  depreciation  and   amortisation  divided  by  total  assets,  and  expressed  in  terms  of  percentage.     Size   A  firm’s  size  is  also  associated  with  the  degree  of  leverage.  Traditional  trade-­off  theory   believes  larger  firms  will  be  more  likely  to  choose  debt  financing,  because  risk  can  be   diversified  by  wider  range  of  operation  activities,  unless  the  firm  is  facing  a  financial  crisis.   However,  Rajan  and  Zingales  (1995)  anticipated  that  larger  firms  have  less  problems  with   asymmetric  information,  and  hence  tend  to  select  equity  financing  when  compared  to   smaller   firms.   Beck   et   al.   (2008)   also   proves   the   importance   of   firm   size   in   financing   decisions  of  companies.  Their  study  found  a  negative  correlation  between  firm  size  and   usage  of  external  financing.  In  another  words,  they  confirm  that  larger  firms  tend  to  use   external  capital  more  frequently  than  smaller  ones.  
  • 22. 22 Firm  size  log(St)  is  defined  as  the  log  of  net  sale/revenues.   Tangibility   Generally,  if  a  firm  holds  large  quantity  of  tangible  assets,  they  will  be  more  willing  to  use   debt  because  fixed  assets  are  normally  considered  as  collateral  of  debt.  Thus,  higher   tangibility  indicates  higher  capacity  of  using  debt,  and  the  majority  of  studies  discover  a   positive  relationship  between  the  amount  of  fixed  assets  and  the  level  of  leverage.  The   result  is  also  in  line  with  both  trade-­off  theory  and  pecking  order  theory.     Tangibility  (PPE/At)  here  is  defined  as  net  property,  plant  and  equipment  divided  by  total   assets  in  percentage  terms.  In  some  literature,  tangibility  is  also  known  as  the  ratio  of   fixed  assets  to  total  assets.     Growth   The  growth  opportunity  of  a  firm  is  measured  as  Tobin’s  q.  This  measurement  is  proposed   by  Tobin  (1969)  to  assess  the  growth  opportunity  of  a  firm.  Generally,  the  Tobin’s  q  has   a   negative   relationship   with   the   degree   of   leverage.   A   firm   with   the   larger   growth   opportunity  tends  to  rapidly  expand  their  business  and  the  process  is  accompanied  with   huge  expenditure.  Thus,  companies  are  reluctant  to  use  debt  in  order  to  avoid  heavy  debt   burdens  or  even  financial  collapse.  In  research  by  Shyam-­Sunder  and  Myers  (1999),  the   importance  of  growth  opportunity  as  well  as  the  inverse  relationship  between  Tobin’s  q   and   leverage   was   proven.   On   the   basis   of   traditional   trade-­off   theory,   the   negative   relationship  is  reasonable  as  it  stated  that  firms  with  higher  growth  rates  may  suffer  from   higher  bankruptcy  costs  when  using  debt.  However,  the  inverse  relationship  seems  to   have   some   conflict   with   pecking   order   theory,   which   claims   the   growth   opportunities   should  be  supported  by  debt  financing  instead  of  equity.  In  short,  there  is  a  negative   relationship  between  growth  opportunities  and  leverage  under  trade-­off  theory,  while  it  is   positive  under  pecking  order  theory.   Tobin’s  q  (or  the  q  ratio)  is  defined  as  total  market  value  of  firm  divided  by  total  assets.  
  • 23. 23 However,  there  is  similarity  in  calculations  of  Tobin’s  q  and  Market-­to-­book  value.  They   have  a  Pearson  correlation  of  1,  which  means  they  have  multi-­collinearity  in  the  initial   analysis.  Hence,  this  variable  is  abandoned  from  the  linear  regression.     Table  4  Summary  of  Variable  Definitions   Table  4  gives  a  summary  of  variable  definitions.  All  of  them  originally  follow  the  research   of  Fama  and  French  (2000).  Many  studies  like  research  of  Yu  (2008)  have  also  cited   these  variable  definitions.   3.2  Hypothesis  and  Models     This  paper  aims  to  answer  three  questions:  1)  Whether  market  timing  exists  in  Hong  Kong   listed   companies;;   2)   Whether   market   timing   will   have   short-­term   influence   on   capital   structures;;   and   3)   Whether   market   timing   will   have   long-­lasting   (more   than   10   years)   influence  on  capital  structure.   Based  on  the  result  of  the  market  timing  theory  test  in  Baker  and  Wurgler  (2002),  three   hypothesis  corresponding  to  the  three  questions  are  stated  in  this  part.  
  • 24. 24 3.2.1  Hypothesis  1  Existence  of  Market  timing     Hypothesis  1:  Market  timing  exists  both  in  debt  and  equity  financing  of  Hong  Kong  listed   companies   Research  by  Hovakimian  te  al  (2001)  found  that  firms  face  obstacles  in  achieving  their   optimal  capital  structure.  In  order  to  reach  the  target  debt  ratio,  a  firm  has  to  choose   whether  to  repurchase  equities  or  retire  debts,  a  process  which  is  highly  related  to  market   timing.  Furthermore,  according  to  Hovakimian  (2004),  equity  market  timing  depends  on   the  market  situations.  Under  the  circumstance  of  good  market  performance,  the  market   to  book  value  will  be  higher,  and  firms  tend  to  issue  equity  to  raise  capital;;  under  a  more   bearish  market,  which  is  reflected  in  lower  market  to  book  value,  firms  tend  to  repurchase   shares.   Model  1  Existence  of  equity  market  timing  in  Hong  Kong  listed  company     Model  1  aims  to  test  the  relationship  between  market-­to-­book  value  with  two  different   ways  of  external  financing,  while  simultaneously  controlling  for  the  last  three  variables.   Yt=  (EQUI/At,  DEBT/At,  DEBT/At,m)   Yt  here  is  the  dependent  variable,  which  represents  three  indicators:  1)  Amount  of  net   equity  financing  divided  by  total  assets  (EQUI/A)  t;;  2)  Book  leverage  (DEBT/A)  t;;  3)  Market   leverage  (DEBT/A)  t,m.  These  three  variables  are  used  to  test  whether  market  timing  exist   in  debt  financing  or  equity  financing.  Both  book  and  market  leverage  are  used  in  order  to   conduct  a  more  comprehensive  investigation.   (M/B)  t  is  the  market  to  book  value,  which  is  the  indicator  of  market  timing  behaviour.  If   the  market  timing  theory  holds,  this  ratio  will  exhibit  a  positive  relationship  with  equity   financing  and  a  negative  one  with  leverage,  because  higher  market  to  book  ratio  indicates  
  • 25. 25 the  market  is  in  a  state  of  flourishing,  and  a  firm’s  stock  is  more  likely  to  be  overvalued,   leading  the  firm  to  choose  issue  equity.     There  are  three  control  variables  here:  (EBITDA/A)  t,  log  (S)  t  and  (PPE/A)  t.  These  three   determinants  of  capital  structure  are  used  in  Model  1  in  order  to  test  how  they  will  affect   financing  behaviour.     (EBITDA/A)  t  is  the  Earnings  before  interest,  tax,  depreciation  and  amortisation  divided  by   total  assets  and  expressed  in  percentage  form.     log  (S)  t  is  the  log  of  net  sale  of  firm.   (PPE/A)  t  is  Net  property,  plant  &  equipment  divided  by  total  assets  and  expressed  in   percentage  form.   3.2.2  Hypothesis  2:  Short-­term  effect     Hypothesis  2:  Market  timing  behaviour  has  short-­term  effects  on  the  capital  structure  of   Hong  Kong  listed  companies   Plenty  of  literature  have  proven  the  short-­term  effect  of  both  equity  and  debt  market  timing.   However,  Liu  and  Li  (2005)  held  a  negative  result  in  China.  They  found  that  though  equity   market-­timing   behaviour   exists   in   the   Chinese   market,   they   do   not   have   significant   influence  on  firms’  capital  structures.  This  paper  still  assumes  there  is  a  short-­term  effect   in  Hong  Kong  listed  companies,  because  the  research  of  Liu  and  Li  (2005)  indicates  the   market-­timing  theory  is  not  a  suitable  application  for  emerging  market,  while  Hong  Kong   is  a  developed  area.   Model  2:  Short-­run  effect  of  equity  market  timing  on  capital  structure     Model  2  aims  to  test  the  short-­term  effects  of  market-­timing.  Hence  the  data  from  the  last   period  is  also  used  in  order  to  test  the  relationship  between  the  change  of  leverage  and   market-­timing  behaviour.  
  • 26. 26 (D/A)t-­(D/A)t-­1   is   the   dependent   variable   in   this   model,   which   represents   the   change   between  leverage  in  this  period  and  that  of  the  last  one.  Both  book  and  market  leverage   are  tested  in  the  linear  regression.     (D/A)t-­1  is  a  lagged  leverage  variable  and  is  restricted  between  0  and  1.  In  Baker  and   Wurgler  (2002),  the  lagged  average  has  a  negative  sign,  but  they  did  not  report  it  in  their   results.  They  use  this  variable  in  their  model  because  they  are  restricted  to  a  certain  range,   which  means  they  can  only  go  in  one  direction,  and  thus  it  can  be  used  as  a  control   variable.   Other  variables  are  same  as  that  in  the  last  model,  except  that  data  from  previous  periods   is  used  here.   3.2.3  Hypothesis  3:  Persistent  effect     Hypothesis  3:  Market  timing  behaviour  has  persistent  effect  on  capital  structure  of  Hong   Kong  listed  companies   As   mentioned   in   the   literature   review   part,   the   “external   finance   weighted-­average"   market-­to-­book  ratio  is  used  as  a  proxy  of  accumulated  historical  market  valuation.  Some   researches   confirm   the   long-­lasting   effect,   such   as   Huang   and   Ritter   (2009),   but   Alti   (2006),  Flannery  and  Rangan  (2006)  doubt  the  presence  of  persistent  effects  of  market   timing  as  they  only  proved  the  temporary  influence  and  failed  to  find  the  long-­term  one.   Followed  the  study  of  Baker  and  Wurgler  (2002,  this  dissertation  hypothesises  that  the   persistent  effect  exists.     Model  3:  Persistent  effect  of  equity  market  timing  on  capital  structure       Model  3  mainly  focuses  on  the  effect  of  the  accumulative  change  since  the  IPO,  and  is   designed  to  compare  the  effect  between  the  external  finance  weighted-­average  market-­ to-­book  value  (M/B)efwa  and  the  lagged  market  to  book  value  (M/B)t-­1.  
  • 27. 27 (M/B)efwa   is   the   external   finance   weighted-­average   market-­to-­book   value,   which   represents  the  accumulated  historical  effect  of  equity  market  timing  behaviour.  However,   the  market  to  book  value  is  also  applied  in  this  model  to  distinguish  the  accumulative   effect  and  the  periodical  influence  from  the  last  period.     The  dependent  variable  simply  adopt  leverage  but  not  the  change  of  leverage  like  in  the   Model  2  because  (M/B)efwa  is  already  contains  historical  information.  Thus,  the  persistent   effect  since  the  IPO  time  to  each  period  can  be  directly  observed  by  using  periodical   leverage.   Other  variables  are  the  same  as  that  in  the  last  model.        
  • 28. 28 4.  Data     This   paper   use   both   the   Bloomberg   database   and   the   Thomson   One   DataStream   database.   The   Bloomberg   database   is   used   to   generate   the   list   of   companies   which   issued   IPOs   from   2005   to   2015   in   the   Hong   Kong   stock   market,   together   with   the   International  Securities  Identification  Numbers  (ISIN)  of  those  IPOs.  Subsequently,  by   using  their  ISIN  code,  specific  data  for  variables  like  Market  to  book  ratio  is  acquired  from   the  DataStream  database.  Data  is  processed  by  IBM  SPSS  23.0.  The  main  statistical   method  is  linear  regression  and  t-­test  of  sample.     There  are  two  types  of  samples:  1)  IPO  subsample,  and  2)  Calendar  year  sample.     According   to   different   offer   times   of   different   IPOs,   data   is   classified   into   several   subsamples  as  IPO,  IPO+1,  IPO+3,  IPO+5,  IPO+7  and  IPO+9.  For  instance,  if  firm  A   issued  an  IPO  in  2000,  data  for  this  firm  in  2001  will  be  included  into  the  subsample  of   IPO+1.  Equivalently,  if  firm  B  issue  IPO  in  2005,  data  for  this  firm  in  2006  will  be  included   into  the  subsample  of  IPO+1.  Thus,  one  subsample  (like  IPO+1)  can  contain  data  of   different   companies   in   different   years.   Eventually,   data   of   227   Hong   Kong   listed   companies  within  the  eleven-­year  period  (including  the  pre-­IPO  year)  is  required  and  used   for  analysis  in  this  paper.  In  IPO  subsamples,  the  subject  of  observation  is  the  individual   firms.  Classifying  data  into  samples  according  to  time  makes  it  easier  to  understand  how   a   firm’s   leverage   or   financing   structure   changes   since   the   issue   of   its   IPO.   Detailed   changes  in  each  year  can  be  required  from  running  regressions  in  each  subsample.   Compared  to  IPO  subsamples,  calendar  year  samples  are  more  integral.  The  duration  of   observation  in  this  dissertation  is  11  years  (includes  the  pre-­IPO  year),  and  calendar  year   subsamples  just  break  this  time  period  into  4  parts.  For  example,  in  the  first  subsample   of  2005-­2007,  data  of  IPOs  issued  in  2005,  2006  or  2007  will  be  included.  Also,  the  IPO+1   and  IPO+2  subsamples  data  of  a  firm  that  issues  its  IPO  in  2005  will  be  included  as  well   because  for  this  company,  IPO+1  means  the  year  of  2006  and  IPO+2  means  that  of  2007.   Calendar  year  samples  focus  more  on  the  market  trend  as  it  assesses  all  firms  in  a  certain   time  period  together,  and  it  allows  an  individual  firm  to  be  observed  multiple  times.  
  • 29. 29 Similar  to  the  majority  of  empirical  studies,  in  order  to  winsorise  our  sample,  this  paper   excludes  companies  that:  1)  Are  in  financial  industry,  due  to  the  characteristic  of  financial   corporations  (Liu  and  Li,  2005);;  2)  Do  not  provide  consolidated  financial  statements;;  3)   Has  leverage  higher  than  1  or  lower  than  0  (Yu,  2008);;  and  4)  Has  market  to  book  value   over  10  (Baker  and  Wurgler  2002)  By  applying  these  conditions,  the  outliers  can  be  avoid   and  stationarity  can  be  improved,  especially  when  the  observing  time  horizon  includes   the  period  of  2008-­09  financial  crisis.        
  • 30. 30 5.  Results  and  Analysis     5.1  Existence  of  market  timing  behaviour       Table  5  Summarised  Statistics  of  Capital  Structure  and  Financing  Decisions   Table  5  summarises  the  statistical  results  of  the  analysis  looking  at  the  change  in  both   book  and  market  leverage  and  the  components  of  capital  structure.     Panel   A   organizes   data   by   IPO   subsamples,   and   6   different   sub-­samples   of   IPO   are   selected.  As  stated  in  the  section  on  data,  the  IPO  subsamples  are  designed  to  observe   trends  of  individual  firms.  A  decline  of  book  leverage  can  be  observed  after  the  IPO  issue.   The  trend  lasts  for  1  year  and  the  book  leverage  recovers  little  by  little  in  the  next  9  years.   The  process  is  slow  and  time-­consuming  as  it  takes  9  years  for  the  mean  value  of  book   leverage  to  recover  to  the  initial  level.  It  is  worth  noting  that  there  is  a  change  in  the   method   of   financing   after   the   issue   of   IPO.   In   the   IPO+1   sample,   the   portion   of   debt   finance  has  a  notable  increase  while  the  portion  of  equity  financing  has  an  inverse  change.   In  other  words,  after  the  issue  of  IPO,  firms  tend  to  change  their  way  of  raising  capital   from  equity  to  debt.     Panel  B  sorts  data  by  calendar  year.  In  this  sections,  samples  are  analysed  in  a  cross-­ sectional  manner  as  all  firms  during  that  period  of  time  are  observed  together,  and  the  
  • 31. 31 same   firm   may   be   observed   multiple   times,   and   thus   calendar   year   samples   more   accurately  reflect  the  general  market  situation.  The  overall  trend  is  the  increase  of  market   leverage  and  decrease  in  equity  issue.  The  increase  in  market  leverage  indicates  that  the   market  value  of  firms  is  becoming  lower,  thus  firm  will  not  issue  equity,  but  will  raise  capital   from  debt  instead.  According  to  the  market  timing  theory,  firms  issue  equity  when  the   market  value  is  high  (or  stocks  are  overvalued),  and  thus  the  amount  of  equity  issues   should  decrease  when  market  value  becomes  lower.  The  result  in  Table  5  is  consistent   with  market  timing  theory.   Market-­timing  behaviour  not  only  refers  to  equity  market  timing  in  stock  market,  it  also   includes   market   timing   of   debt   (Hovakimian,   2004).   The   Pearson   linear   correlations   between  the  two  dependent  variables  and  the  four  independent  variables  are  checked   before  running  the  linear  regression.  Results  are  shown  in  the  table  below.     Table  6  Pearson  Correlation  between  Variables   Results  from  Table  6  show  the  M/B  value  has  a  positive  correlation  with  net  equity  issue   and  a  negative  correlation  with  debt  financing.  It  also  shows  results  of  three  different   regressions,   where   the   dependent   variables   are   net   equity   issue,   book   leverage   and   market  leverage  respectively.  
  • 32. 32 Generally,  the  M/B  ratio  reflects  the  current  market  situation.  Higher  M/B  ratio  indicates  a   bull   market,   which   also   means   firm’s   share   price   has   higher   possibility   to   be   overestimated,   and   thus   firms   will   issue   IPOs   at   this   time   to   take   advantage   of   the   mispricing.  Contrastingly,  when  the  M/B  value  is  lower,  firms  will  switch  to  debt  financing   to   avoid   underestimation   of   their   stock   prices.   The   result   shows   when   the   M/B   ratio   changes  in  the  same  direction  with  equity  issue  and  changes  in  an  opposite  direction  with   leverage,  which  meets  the  expectations  of  market  timing  theory.   Profitability  here  has  a  positive  correlation  with  equity  financing  and  a  negative  one  with   leverage.   This   result   demonstrates   that   when   Hong   Kong   listed   companies   possess   stronger   profitability,   they   are   more   likely   to   raise   funds   internally   from   the   retained   earnings,  and  thus  the  amount  of  debt  will  decrease.  Equity  issuing  provides  firms  extra   funds,  thus  leading  to  higher  profitability.  Marsh  (1982)  explains  that  profitability  can  be   viewed  as  an  indicator  of  the  timing  effect,  as  firms  with  higher  earnings  tend  to  be  those   that  are  enjoying  significant  increases  in  stock  price.     Firm’s  size,  which  is  represented  by  the  log  value  of  net  sales,  show  a  positive  relationship   with  debt.  The  result  means  larger  Hong  Kong  listed  companies  are  more  willing  to  use   debt.  Larger  firms  are  usually  more  diversified.  Research  from  Wan  (1998)  pointed  out   that  Hong  Kong  firms  that  are  more  diversified  do  not  necessarily  have  higher  profitability.   Instead,   higher   levels   of   diversification   only   have   positive   effects   on   the   stability   of   profitability.  Hence,  larger  firms  with  a  wider  range  of  operations  are  more  willing  to  use   debt  because  they  have  stable  earnings,  and  thus  bear  less  risk.   Finally,   tangibility   has   a   positive   relationship   with   debt   use,   and   the   value   of   positive   correlation  is  higher  than  that  between  firm  size  and  debt.  The  result  shows  a  more  direct   and  positive  relationship  and  is  consistent  with  both  trade-­off  and  pecking  order  theory,   as  well  as  the  majority  of  empirical  studies  on  this  subject.  It  proves  the  importance  of   tangible  assets  as  collateral  in  borrowing  debt.   However,  the  Pearson  correlation  just  provides  a  general  glance  of  variables.  Precise   analysis  of  relations  between  variables  need  to  be  confirmed  by  the  coefficients  of  linear  
  • 33. 33 regression.   Applying   the   Model   1   introduced   in   the   methodology,   coefficients   among   variables  are  acquired  and  shown  in  the  table  below.     Table  7  Coefficients  of  Model  1a   Model  1a  is  designed  to  study  the  relationship  between  net  equity  issue  and  equity  market   timing  and  the  results  are  shown  in  Table  7.  Though  the  R-­square  of  this  model  is  0.083,   the  t-­test  of  all  independent  variables  are  highly  significant.  The  result  shows  the  market   to  book  value  has  a  significant  effect  in  issuing  equity  and  further  confirms:  1)  The  positive   relationship  between  equity  issue  and  equity  market  timing;;  2)  the  positive  relationship   between  equity  issue  and  profitability;;  3)  the  negative  relationship  between  equity  issue   and  firm  size;;  and  4)  the  negative  relationship  between  equity  issue  and  tangibility.     Table  8  Coefficients  of  Model  1b  &1c  
  • 34. 34 Table  8  summarises  results  of  book  leverage  and  market  leverage  by  applying  Model  1.   It  explains  that  market  timing  behaviour  is  an  important  issue  to  be  considered  when   making  debt  financing  decisions.  In  contrast  to  the  result  in  Model  1a,  it  further  proves:  1)   The  negative  relationship  between  debt  financing  and  firm’s  market  value;;  2)  the  negative   relationship  between  debt  financing  and  tangibility;;  3)  the  positive  relationship  between   debt  financing  and  firm  size;;  and  4)  the  positive  relationship  between  debt  financing  and   tangibility.   Based   on   all   results   from   linear   regressions,   hypothesis   1   cannot   be   rejected.   I   can   conclude  that  market  timing  behaviour  exists  both  in  equity  and  debt  financing  decisions   of  Hong  Kong  listed  companies.  Firms  choose  equity  issue  when  the  market  value  is  high   and  select  debt  financing  otherwise.     5.2  Short-­term  effects  of  market  timing  behaviour     Model  2  described  in  the  methodology  is  used  to  test  for  short-­term  effects.  Compared  to   Model  1,  the  dependent  variable  adopts  the  difference  of  leverage  of  current  period  and   that   of   the   last   period   in   order   to   test   the   effect   of   a   temporary   change   of   leverage.   Coefficients  of  variables  are  acquired  and  shown  in  the  table  below.     Table  9  Coefficients  of  Model  2a   According  to  Table  9,  all  variables  are  significant  at  1%  level  of  significance.    
  • 35. 35 Profitability  has  a  relative  strong  linear  relationship  with  the  change  in  capital  structure,   and  the  effect  is  negative.  As  stated  before,  the  result  meets  the  expectation  of  pecking   order  theory,  and  indicates  that  the  Hong  Kong  market  is  like  other  developed  markets   that   follow   the   financing   order   under   pecking   order   theory.   Higher   ability   to   generate   earnings  provides  firms  with  sufficient  internal  funds.     The  next  one  is  tangibility.  In  the  short-­run,  tangibility  plays  an  important  role  in  a  firm’s   capital  structure.  The  beta  shows  that  when  there  is  a  1  percent  increase  in  tangibility   (PPE/A  t),  there  will  be  a  0.12  percent  increase  in  the  book  leverage.     Compared  to  profitability  and  tangibility,  market  timing  seems  less  important  from  the   perspective   of   effect   on   capital   structure.   It   proves   that   though   a   manager’s   timing   behaviour  indeed  has  short-­run  influence  on  capital  structure,  how  much  it  changes  still   largely  depends  on  the  firm’s  willingness  and  ability  to  raise  debt.   The   lagged   term,   DEBTt-­1   has   the   strongest   correlation   with   the   change   in   leverage.   Similar  to  the  result  in  Baker  &  Wurgler  (2002),  the  relationship  is  strongly  negative,  but   they  did  not  report  the  statistical  result  of  this  variable  in  their  paper.  The  lagged  variable   is   included   because   the   amount   of   leverage   in   the   last   period   will   definitely   has   a   significant  influence  on  the  result  of  changes  in  leverage,  and  therefore  it  needs  to  be   controlled  in  order  to  avoid  adverse  effects  on  other  variables.       Table  10  Coefficients  of  Model  2b  
  • 36. 36 One  interesting  thing  is  that  the  result  of  market  leverage  always  has  higher  degree  of   significance  than  that  of  book  leverage  in  each  single  regression  thus  far.  Overall,  the   sign  of  results  of  market  leverage  are  the  same  as  those  in  the  previous  model.  However,   they  are  more  significant  and  the  model  has  higher  R-­squared.  One  possible  explanation   is  that  book  leverage  reflects  more  about  the  operation  of  a  company  and  will  be  modified   before  publishing,  but  market  leverage  contains  more  information  about  the  market,  and   thus  will  be  more  sensitive  and  will  express  the  change  more  accurately.  Adrian  et  al   (2015)  stated  in  their  staff  report  of  the  Federal  Reserve  Bank  of  New  York  that  “market   leverage  is  nearly  entirely  reflective  of  movements  in  book-­to-­  market  ratios”.  Therefore,   market  leverage  tends  to  have  more  significant  results.     Model  2  is  designed  to  test  the  short-­term  effect  of  market  timing  behaviour  on  capital   structure.  According  to  the  results  of  the  t-­test,  hypothesis  2  cannot  be  rejected.  In  short   time  horizons,  market  timing  has  significant  influence  on  financing  actions  and  has  direct   effects  on  changes  of  leverage.  However,  the  primary  reason  behind  the  change  is  firms’   desire  and  ability.   5.3  Persistent  effect  of  market  timing  behaviour     Model  3  introduces  a  new  variable  created  by  Baker  &  Wurgler  (2002).  First  of  all,  data   of  all  time  periods  is  analysed  in  a  cross-­sectional  manner  in  the  regression,  and  the  result   is  shown  in  the  table  below.     Table  11  Coefficients  of  Model  3a  
  • 37. 37 From   Table   11   shows   that   during   the   ten-­year   period,   both   (M/B)efwa   and   (M/B)t-­1   are   significant,  but  the  periodical  market  timing  seems  much  more  closely  related  to  leverage   than  the  accumulated  historical  behaviour.  In  this  model,  the  result  indicates  that  instead   of  past  timing  actions,  the  periodical  adjustment  of  a  firm’s  leverage  has  greater  influence   on  its  capital  structure.  This  outcome  is  more  likely  to  follow  the  trade-­off  theory  that   managers   rectify   and   rebalance   for   the   target   capital   structure   based   on   the   current   market  situation.  However,  Baker  &  Wurgler  (2002)  emphasizes  that  market  timing  is  the   result  of  accumulated  actions  of  timing,  and  the  impact  of  (M/B)efwa  is  obviously  more   significant  and  accurate  than  the  variable  of  (M/B)t-­1.  This  model  only  examines  from  a   single  point  of  time,  and  cannot  show  the  continuous  change  from  year  to  year.  Hence,   in  order  to  further  compare  influence  of  these  two  variables,  detailed  statistical  analysis   in  each  subsample  is  necessary.   Instead  of  using  cross-­sectional  data,  time-­series  regressions  of  each  subsample  are   presented  in  the  table  below.     Table  12  Summary  of  coefficients  in  subsamples1   Results  of  four  subsamples,  including  IPO+1,  IPO+3,  IPO+5  and  IPO+10,  are  shown  in   Table  12.  Coefficients  of  all  firms  from  2005  to  2015  have  already  been  illustrated  in  Table   11,  but  are  shown  here  to  facilitate  comparison.     1 Subsample of IPO+10 here combines the data of IPO+9 and IPO+10 because initially there are only 26 companies in the IPO+10, which is less than 30, and the small sample size may cause bias in the result. Thus data from the end of IPO+9 is added.
  • 38. 38 As  can  be  seen,  the  (M/B)efwa  variable  becomes  more  significant  as  time  passes,  and   turns  into  the  most  significant  one  in  the  IPO+10  sample.  Compared  to  the  result  of  all   firms  in  the  10  years,  this  result  shows  the  gradual  progress  and  proves  the  continuous   effect  of  historical  market  timing  attempts.     The   interesting   thing   is   that   after   the   introduction   of   (M/B)efwa   ,   (M/B)t-­1   becomes   less   significant  when  data  is  observed  by  independent  IPO  subsamples.  (M/B)t-­1  only  passes   the  significance  test  in  the  IPO+1  sample.  At  the  end  of  year  10,  the  coefficient  of  (M/B)t-­ 1  becomes  positive,  which  is  the  same  in  the  study  of  Baker  &  Wurgler  (2002).  Hence,  the   result   explains   why   when   the   data   is   observed   in   a   continuous   process,   the   external   finance   weighted-­average   market-­to-­book   value   performs   better   than   normal   lagged   market-­to-­book  value.     Like  all  the  results  before,  the  presence  strong  tangibility  is  always  a  stable  support  for  a   firm   to   debt.   The   positive   correlation   has   been   proven   in   all   models.   Similarly,   the   coefficient  for  profitability  is  always  inverse  to  that  of  tangibility,  and  profitability  is  always   negatively   correlated   with   leverage.   Nevertheless,   the   importance   of   firm   size   in   the   financing  structure  is  diminishing  as  time  passes.  In  the  IPO+10  sample,  firm  size  is  not   a  significant  variable,  which  indicates  that  the  scale  of  firms  does  not  matter  that  much  in   the  long  run.  Like  the  principle  of  diminishing  rate  of  return,  initially,  larger  scale  can   diversify  a  firm’s  risk  and  stabilize  their  profitability.  However,  in  the  long  run,  when  their   competitors  reach  a  similar  level  of  scale  and  the  market  is  quite  stable,  the  advantages   that  large  size  once  brought  will  vanish.   To  summarize,  if  data  is  being  studied  in  a  cross-­sectional  manner,  market-­to-­book  value   is  significant  and  indicates  that  periodical  adjustments  of  managers  affect  capital  structure.   However,   if   the   data   is   analysed   across   time,   in   the   long-­term,   the   external   finance   weighted-­average   market-­to-­book   value   is   more   powerful,   because   the   effect   is   cumulative,  and  becomes  more  significant  with  time.  No  matter  which  method  is  used  in   which   model,   the   external   finance   weighted-­average   market-­to-­book   value   is   always   significant.  Thus,  hypothesis  3  cannot  be  rejected,  and  a  conclusion  can  be  drawn  that   market  timing  does  have  a  persistent  effect  on  capital  structure  that  may  last  for  about   ten  years.  
  • 39. 39 6.  Conclusion     6.1  Limitations       In  sum,  this  dissertation  has  significant  results  and  answers  the  three  questions  listed  in   the  section  outlining  our  objectives.  However,  many  limitations  still  exist  and  may  have   an  adverse  influence  on  the  accuracy  of  the  research.   First  of  all,  the  data  is  ranges  from  2005-­2015.  Due  to  the  financial  crisis  of  2008-­09,  many   listed  companies  have  abnormal  values  of  book  leverage  and  especially  market  leverage,   and  even  lack  of  data.  In  order  to  avoid  the  bias  of  extreme  values,  conditions  have  been   applied   when   selecting   the   companies.   For   instance,   like   stated   in   the   methodology,   companies  with  market  to  book  value  exceeding  10,  and  with  book  leverage  below  0  or   over  1  are  all  removed  from  the  sample.  Those  restrictions  aid  to  remove  the  influence  of   the  crisis  to  a  relatively  large  extent,  but  it  leads  to  the  shrinkage  in  sample  size  as  well.   Data  of  many  companies  have  been  deleted  because  either  one  of  the  or  both  of  the   variables  cannot  meet  these  requirements.  The  IPO  sample  in  2008  only  contains  6  listed   companies  and  their  IPOs.  In  the  analysis  of  Model  3,  the  subsample  IPO+10  is  actually   a  combined  one  of  subsample  IPO+9  and  IPO+10,  because  IPO+10  only  includes  26   listed  companies,  which  is  below  the  minimum  sample  size  of  30,  and  cannot  be  tested   as  a  normal  distribution.     Secondly,  similar  to  research  done  by  Baker  &  Wurgler  (2002),  this  dissertation  did  not   manage  to  distinguish  between  the  effects  of  market  timing  from  perceived  mispricing  or   adverse  selection.  More  data  and  models  are  required  to  do  precise  tests  for  these  two   types  of  market  timing.  It  can  be  conducted  by  following  the  example  of  Chazi  (2004),   where  he  quantifies  the  perceived  mispricing  and  adverse  selection  by  using  net  insider   trading  and  checks  the  relationship  between  net  insider  trading  and  leverage.  Additionally,   he  adds  different  dummy  variables  for  the  two  types  of  market  timing.      
  • 40. 40 6.2  Summary   This   dissertation   aims   to   study   the   relationship   between   market   timing   and   capital   structure  in  Hong  Kong.  This  dissertation  proves  the  existence  and  long-­lasting  effects  of   market  timing  behaviour  on  changes  in  capital  structure  in  Hong  Kong  listed  companies   from  2005  to  2015.  The  main  contribution  is  providing  evidence  from  an  area  that  few   people  have  studied  before,  which  is  Hong  Kong,  and  the  use  of  a  new  time  period.  The   result  is  consistent  with  the  majority  of  literature  based  on  developed  markets.   It  turns  out  that  market  timing  behaviour  universally  exists  in  Hong  Kong  listed  companies,   from  both  the  equity  and  debt  financing  perspectives.  Firms  tend  to  issue  IPOs  when  their   market  value  is  high,  and  choose  debt  otherwise.  In  the  short  run,  capital  structure  can   be  affected  by  market  timing  behaviour,  but  it  will  be  influenced  by  the  firm’s  tangibility   and  profitability  to  a  greater  degree.  In  the  long  run,  market  timing  actions  have  persistent   effects.  At  each  time  period,  firms  rebalancing  to  the  movement  of  equity  markets  is  vital.   The  accumulated  timing  behaviour  has  a  greater  importance  as  time  passes.  This  result   can  be  considered  as  evidence  of  the  application  of  market  timing  in  Hong  Kong.                    
  • 41. 41 Appendices     Figure  1  Static  Trade-­off  Theory   The  graph  above  is  referred  from  Robichek  &  Myers  (1966).  The  graph  shows  the  dual   characteristics  of  debt.  On  the  one  hand,  debt  increases  the  firm  value  and  lets  the  firm   benefit  from  tax  shields.  On  the  other  hand,  debt  potentially  inflicts  upon  firm’s  higher   bankruptcy  costs  and  agency  costs.     Figure  2  Trade-­off  Model  Based  on  Agency  Cost  
  • 42. 42 The  graph  above  is  referred  from  Myers  &  Majluf  (1984).  It  explains  that  in  the  process  of   reaching  the  optimal  capital  structure,  a  firm  always  faces  the  problem  of  agency  cost  no   matter  whether  the  firm  chooses  debt  financing  or  equity  financing.     Table  1  Sources  of  Net  Capitals  in  Developed  Countries   The  table  above  uses  data  from  Corbett  &  Jenkinson  (1996).  It  proves  the  pecking  order   theory   by   providing   evidence   from   several   developed   countries.   The   data   shows   that   these  countries  consider  internal  finance  as  their  absolute  first  choice.      
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