Friday, November 12, 2004

Alti finds Market Timing's leverage impact is largely transitory

Two for the price of one today! We have two papers today that both give us more evidence that suggests that firms do “time the market” with respect to capital issuance (and consequently capital structure), but that the firms try to get back to their targeted capital structure quite quickly.

What makes it interesting (and not repetitive) is that each paper (Flannery and Rangan and Alti) each get to this same conclusion from different starting points.

We will go alphabetically and begin with Alti.

In a paper that is to be presented at the American Finance Association meetings, Ayogan Alti looks at hot and cold IPO markets. As the names “hot” and “cold” suggest, he finds that firms do time the market. Not only do more firms issue during hot markets, but also the issuers raise more capital during the hot periods. (During hot periods Alt reports that firms raise 102% of previous assets whereas during cold period the firms only raise 67% of their pre-issuance assets.).

What is somewhat novel is Alti’s next finding: that this initial capital structure choice (less leverage in hot periods) is quite transitory. Firms revert back to some target capital structure relatively quickly. In his words:
"The IPO-year market timing effect on leverage has very low persistence. One year after the IPO, only about one half of the effect remains. Two years after the IPO, the hot-market effect is completely dead, never to revive again. Hence market timing appears to have only a short-term impact on capital structure. An analysis of financing activity in these two years reveals that hot-market firms follow an active policy of reversing the timing effect on leverage. Cold-market issuers are content with the leverage ratios they attain at the IPO"
This finding contradicts some previous literature (for instance Baker and Wurgler, JF 2002). Why the difference? Alti speculates that it is because previous work often used the market to book ratio as a measure of market timing. This can be problematic since the market to book ratio also proxies for growth opportunities available to the firm.

While previous authors recognize this flaw and attempt to control for it, “this control is likely to be very noisy.”

So what does this paper add to our knowledge? It adds more evidence that in spite of market efficiency claims that the price is always just a price and thus there is no good or bad time to issue, corporate managers believe they can time the market. They issue more equity when they feel the market is “hot”.

More importantly the paper shows that this capital structure impact of this market timing behavior is largely transitory. In the longer term, firms do seem to have a target (which is presumed to be an optimal) capital structure in mind. Which nicely jives with the trade-off theory of capital structure.

It shuld be noted, that this conclusion is very similar to that of Mayer and Sussman which we discussed a few days ago.

Alternative sites where this paper can be downloaded
(or cites if you prefer---pun intended ;) )

From SSRN:
Suggested Citation
Alti, Aydogan, "How Persistent is the Impact of Market Timing on Capital Structure?" (October 14, 2003). University of Texas at Austin Working Paper; 6th Annual Texas Finance Festival.

From his web site, and finally from the AFA program.

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