RECENT ACADEMIC FINDINGS
The primary distinction between the trade-off and pecking-order theories is that whereas the notion of target capital structure is central to the former, it is entirely rejected by the latter. Not surprisingly, much of the earlier research related to these theories focused on the merits of one theory and sought to criticize the other. However, some of the more recent literature finds support for components of each. In this section, we examine some of the latest developments in capital structure theory.
Capital Structure Policy and Market Timing
Baker and Wurgler were one of the first authors to introduce a "market-timing" hypothesis for capital structure theory.4 In the context of capital structure, market timing refers to management's effort to take advantage of market conditions to minimize the cost of capital. A manager who is timing the market would choose to issue equity when stock prices are perceived to be overvalued and repurchase equity when stock prices are relatively low. The authors looked at market-to-book ratios as a measure of relative valuation of equity and showed that there is a strong, negative correlation between high levels of leverage and high market-to-book ratios. They interpreted this as evidence that managers do indeed issue stock when prices are relatively high (market-to-book ratios are high) and repurchase stock when prices are relatively low (market-to-book ratios are low). This results in higher levels of debt when stock prices are relatively low and vice versa. This practice of market timing has a persistent impact on long-term capital structure, leading to the conclusion that capital structure is related to historical market values. A comprehensive survey of CFOs supported Baker and Wurgler's findings.5 Two-thirds of respondents said that the perceived over/undervaluation of equity was an important or very important determinant in the decision to issue equity, second only to concerns about the dilution of earnings per share (EPS).
Barry, Mann, Mihov, and Rodriguez explored the relationship between interest rates and the decision to issue debt.6 They found that firms issued significantly higher amounts of debt when long-term interest rates were perceived to be low relative to historical values. Although refinancing activity can explain some of this activity, nonrefinancing activity is also considerably higher when interest rates are relatively low. Baker, Ruback, and Wurgler synthesized the research related to the market timing of financing activities to determine whether or not these timing strategies payoff.7 They concluded that market-timing driven equity issuances seemed to be beneficial because stock prices tended to decline after the equity issuance. This resulted in a lower cost of equity for issuing firms relative to their nonissuing peers. Barry, Mann, Mihov, and Rodriguez found that firms can benefit by selecting the maturity of debt issues based on market conditions.8 In particular, a firm that expects interest rates to increase in the future should issue long-term debt. If the firm expects decreases in interest rates, it should issue short-term debt today, and, at maturity, issue longer-term debt at lower rates. Firms that appeared to be successful at anticipating future interest rates experienced a decrease in the overall cost of debt.
Capital Structure, Historical Stock, and Operating Performance
Hovakimian, Hovakimian, and Tehranian examined the relationship between market and operating performance and the external financing decision by focusing on firms that issued both equity and debt.9 Their study supported hypotheses that firms with high market-to-book values have low leverage ratios and that high stock returns are related to equity issuance. However, they did not find evidence that market performance has a bearing on debt issuance. Furthermore, the study found no relationship between operating performance and target capital structure but did find a relationship between profitability and a firm's response to deviations from target capital structure. As losses accumulated, unprofitable firms experienced a decrease in the value of equity, which caused debt ratios to rise above their targets. These firms tended to issue equity to correct these deviations from target levels of leverage. In contrast, profitable firms experienced an increase in equity as profits accumulated, causing their debt ratios to fall below target values. However, these firms did not issue more debt to correct the deviation. Under these circumstances, firms behaved consistently with pecking-order theory, whereby they used accumulated profits as a source of internal funding rather than issuing more debt. In summary, firms tend to have a target capital structure, but the preference for internal financing and the appeal of market timing tend to distract them from maintaining these target structures.
Welch explored the relationship between historical stock prices and capital structure.10 Sometimes referred to as "inertia theory," Welch hypothesized that firms behave as though they have a target capital structure but are slow to act to reverse diversions from the target. In an analysis of all publicly traded firms between 1962 and 2000, the study found evidence that firms had target debt ratios. In particular, a firm's capital structure was highly correlated to the capital structure in the prior year. Testing the hypothesis over a five-year period, the research found that correlation effects were long-standing, providing further evidence that firms had target debt ratios. However, as stock prices caused a firm's capital structure to move away from its target, firms did not counteract this divergence despite frequent debt and equity issuing activity. Welch found that 60 percent of capital structure was explained by such issuing activity but that this activity was not intended to readjust capital structure when debt ratios changed. In fact, over the long term, 40 percent of firms' capital structure was determined by debt ratio changes resulting from stock price movements, and these changes did not seem to be followed by management actions to readjust capital structure.
Flannery and Rangan studied the capital structure trends of nonfinancial firms between 1966 and 2001.1 1 Although conceding that there are many factors that influence a firm's capital structure, for example, historical stock prices, pecking orders, and market-timing tendencies, they disagreed with Welch's assertion that firms do not readily take action to reverse divergences from the target capital structures due to stock price movements. They suggested that pecking-order and market-timing theories tend to explain about 10 percent of capital structure changes and restructuring toward target levels of leverage explained more than half. When capital structure moves away from the target, firms take actions to move the capital structure back toward the target structure at a rate of more than 30 percent per year, three times more than what other research suggests.