Capital Budgeting vs. Market Timing: An Evaluation Using Demographics

We use demand shifts induced by demographics to provide a novel evaluation of capital budgeting and market timing. Capital budgeting implies that industries anticipating positive demand shifts in the near future should issue more equity to finance capacity. To the extent that demographic shifts in the distant future are not incorporated into equity prices, market timing implies that industries anticipating positive demand shifts in the distant future should issue less equity due to undervaluation. The evidence supports both theories: new listings and equity issuance respond positively to demand shifts up to 5 years ahead, and negatively to demand shifts 5 to 10 years ahead. ∗DellaVigna is from the Department of Economics, University of California, Berkeley. Pollet is from the Department of Finance, Michigan State University. We thank Malcolm Baker, Patrick Bolton, James Choi, Ron Giammarino, Gur Huberman, Christopher Polk, Michael Weisbach, Jeffrey Wurgler, the audiences at Amsterdam University, Columbia University, Dartmouth College, Emory University, Harvard University, Rotterdam University, Tilburg University, UCLA, University of Illinois at UrbanaChampaign, the 2008 AFA Annual Meetings, and the 2008 Texas Finance Festival for comments. We also thank Jay Ritter for providing us with the IPO data set. Finally, we gratefully acknowledge the support of the NSF through grant SES-0418206. The determinants of equity issuance are the subject of an ongoing debate in corporate finance. Are initial and seasoned offerings best explained by the demands for external finance, or are they driven by market timing in response to company misvaluation? Capital budgeting holds that firms issue equity (and debt) to invest the proceeds in positive net-present-value projects, for example to expand production when demand is high (Modigliani and Miller, 1958). Market timing instead holds that firms issue equity to take advantage of mispricing by investors. (Baker, Ruback, and Wurgler, 2007; Stein, 1996). One crucial difficulty in evaluating these theories is the lack of exogenous proxies for investment opportunities, on the one hand, and for misvaluation, on the other hand. For instance, the relationship between the market-to-book ratio and corporate decisions could reflect investment opportunities (Campello and Graham, 2007), mispricing related to accruals or dispersion of opinion (Gilchrist, Himmelberg, and Huberman, 2005; Polk and Sapienza, 2009), or both (Hertzel and Li, 2010). These issues are also linked to whether market-to-book is a proxy for risk (Fama and French, 1992) or a measure of mispricing relative to accounting fundamentals (Lakonishok, Shleifer, and Vishny, 1994). We use demographic variables as proxies for both in a novel evaluation of these two theories. We consider industries that are affected by predictable shifts in cohort sizes, such as breweries and long-term care facilities. These industries have distinctive age profiles of consumption. Therefore, forecastable changes in the age distribution produce forecastable shifts in demand for various goods. Even though these demand shifts only capture a small component of the variation in investment opportunities and mispricing, they are exogenous from the perspective of the manager. As such, they allow us to address the endogeneity problem and identify