Managing Financial Policy Evidence from the Financing of Extraordinary Investments

How do managers set financial policy? Most popular theories of financial policy are developed in terms of a marginal analysis for a new project available to the firm that is extraordinary in spirit. However, extraordinary investment observations have not been previously isolated for study. This paper uses a sample of firms making extraordinary investments to probe deeper into the driving forces behind financial policy theories. Eventtime analysis reveals that the financial policies of the sample firms can reasonably be characterized as “pecking order” behavior as described by Donaldson (1961) and Myers (1984): (1) internal funds are the dominant source; (2) equity issues are relatively unimportant; and (3) debt issues are the residual financing variable. There is no evidence that dividend-paying firms adjust dividend policy to accommodate the extraordinary investment. To address whether this observed pecking order behavior in financial policy is necessarily supportive of the pecking order theory [Myers and Majluf (1984)], I develop a test designed to distinguish between target-adjustment and pecking order models. A competing prediction of the two models concerns what happens to the cash holdings of firms raising external financing. The empirical results suggest (a) transaction costs appear to be an important determinant of financial policies and (b) pecking order behavior does not necessarily provide strong support for the pecking order theory. Harvard Business School, Soldiers Field, Boston, MA 02163, [email protected]. I thank Gregor Andrade, Harry DeAngelo, Doug Diamond, J. B. Heaton, Peter Hecht, Robert McDonald, Lisa Meulbroek, Raghu Rajan, Matthew Rothman, Per Strömberg, Francis Yared, and seminar participants at Columbia, Cornell, Duke, Harvard, NYU, University of Rochester, University of Chicago, USC, and the 1999 WFA Meetings for helpful comments and discussions. I am especially grateful to Eugene Fama, Steven Kaplan, Mark, Mitchell, and Luigi Zingales for their insightful advice and guidance. Financial support from the Oscar Mayer Foundation and the Sanford Grossman Fellowship is greatly appreciated.