NCPA - National Center for Policy Analysis

Attempts To Time The Market Affect Firms' Capital Structure

June 12, 2002

Many theories and models have tried to explain why firms choose to raise capital by issuing stock (equity financing) or borrowing (debt financing). But current theories fail either on empirical grounds or apply only under certain conditions.

In a new effort to understand a firm's choice, researchers propose a new, simple model. They argue that the structure of firms' capital is the unconscious result of their attempts to "time the market" -- issuing shares when prices are high, and repurchasing them when the price is low.

  • This means that companies do not aim at a certain debt-equity ratio, rather they engage in what appears as opportunistic behavior.
  • The authors of the theory show that the effects of this market-timing behavior are persistent over time.
  • Analyzing a sample of 3000 U.S. firms between 1968 and 1998, they found that unleveraged firms are the ones that raised funds when the market value of their stock was high -- with the impact of past market valuations remaining on the balance sheet 10 years later.
  • This suggests that even short-term variations in stock prices can have a long-term effect on a firm's capital structure.

It remains to be seen if this theory will be generally applicable or if, as has happened with past models, it applies only under certain circumstances.

Source: "A Simple Model of Capital Structure," Economic Intuition, Summer 2001; based on Steward C. Myers, "Capital Structure," Journal of Economic Perspectives, Spring 2001, Malcolm Baker and Jeffrey Wurgler, "Market Timing and Capital Structure", Yale International Center for Finance, Journal of Finance, February 2002, John R. Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance," Journal of Financial Economics, May 2001.


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