A Dynamic Model of Corporate Financing with Market Timing

In this paper, I consider a dynamic trade-off model of financing with difference in beliefs between the manager and investors. In the model, investors update more readily on earnings announcements than the manager does. The model offers a parsimonious treatment of endogenous financing, payout, and cash policies. The model generates a broad set of well-documented empirical facts that are difficult to explain using standard theories. In particular, the model predicts: 1) high stock returns predicting equity issuance, 2) the low debt ratios of firms in crosssection, 3) the substantial presence of firms with no debt or negative net debt and the fact that zero-debt firms are more profitable, pay larger dividends, and keep higher cash balances than other firms, and 4) the negative relationship between profitability and both book and market leverage ratios. If investors overextrapolate trends in earnings growth, the model also predicts the negative/positive long-run abnormal returns following stock issuances/repurchases. I am indebted to Ilya Strebulaev, and Peter Demarzo for continuous guidance and encouragement. I am grateful to Darrell Duffie, Paul Pfleiderer, and Jeff Zwiebel for many insightful discussions. I would also like to thank Snehal Banerjee, Dirk Jenter, Stefan Nagel, Paul Povel and seminar participants at University of Minnesota (Carlson), and Stanford University for helpful comments. All remaining errors are mine. Email: yang [email protected].