How Persistent Is the Impact of Market Timing on Capital Structure?

This paper examines the capital structure implications of market timing. I isolate timing attempts in a single major financing event, the initial public offering, by identifying market timers as firms that go public in hot issue markets. I find that hot-market IPO firms issue substantially more equity, and lower their leverage ratios by more, than cold-market firms do. However, immediately after going public, hot-market firms increase their leverage ratios by issuing more debt and less equity relative to coldmarket firms. At the end of the second year following the IPO, the impact of market timing on leverage completely vanishes. EQUITY MARKET TIMING IS ONE OF THE PRIMARY FACTORS that shape corporate financing decisions. A large body of work documents the tendency of firms to issue equity when the cost of equity capital appears to be temporarily low. The evidence is convincing. Studies on market valuations around equity issues are complemented by other findings such as the long-run underperformance of issuers and by survey results of managers (see Sec. I for a detailed review of prior evidence on market timing). While the collective evidence makes a strong case for the presence of market timing attempts, quantifying their impact on financing activity is difficult. Most direct tests of market timing are based on the positive relationship between firms’ market valuations and their equity issues. However, a host of other factors that affect financing policy are likely to contribute to this relationship. For example, firms with growth opportunities, which typically have high market values relative to book assets, may use relatively more equity financing to maintain financial flexibility. Answering quantitative questions about market timing requires a market timing measure that is not so closely tied to other determinants of financing policy. A research question that has recently received considerable attention is the long-term impact of market timing on capital structure. The importance of this issue cannot be overstated: if true, high persistence of market timing effects would imply very loose leverage targets, suggesting a minimal role for traditional determinants of capital structure. In their influential study, Baker and Wurgler (2002) raise the persistence question and offer a striking answer. ∗University of Texas at Austin. I would like to thank Andres Almazan, Rick Green, Charlie Hadlock, Burton Hollifield, Jay Ritter, Ronnie Shah, Sheridan Titman, Jeffrey Wurgler, an anonymous referee, and the seminar participants at the 2004 Texas Finance Festival, 2005 AFA meetings, and University of Virginia for their helpful comments and suggestions.