Another look at Capital Structure and Market Timing

Market Timing with respect to capital structure changes is an interesting and controversial topic that combines capital structure theory with market efficiency theory. On one side of the aisle pure market efficiency proponents maintain there is no place for market timing as the current price is always right. The other side of the discussion is held by those who believe that capital structure tradeoff or pecking order theories are sufficiently robust to capture changes in capital structure.

Most recently is has appeared that the timing camp has been winning. Over the past few years much esearch has shown what the authors interpreted as market timing (that is, issue equity when stock prices are relatively high, issue debt when interest rates are low). For example Baker and Wurgler (2002), Flannery and Rangan (2004), and Alti (2004) all suggest that market timing does occur.

Now Hovakimian draws that interpretation into question. Namely he suggests that timing is less important than the persistent relation between market to book ratios and growth opportunities. Specifically: "These results are consistent with the hypothesis that the importance of historical weighted-average market-to-book is due to its association with current growth opportunities."

In other words:

"results also show that cross-sectional differences in market-to-book ratios of firms issuing and repurchasing debt and equity dwarf the changes in market-to-book experienced by these firms over time."

Interesting! I am not totally convinced that timing does not play a more important role than suggested here, but do (and always have) admit that timing is not the major determinant in capital structure decisions. However, I will be surprised if in the end we do not conclude that it does play a role.

Interesting!

Suggested Citation:
Hovakimian, Armen, "Are Observed Capital Structures Determined by Equity Market Timing?" (June 3, 2003). AFA 2005 Philadelphia Meetings. http://ssrn.com/abstract=413387