Cross-Market Timing in Security Issuance

Finance

Further details

Abstract

How does market timing affect a firm's capital structure? The conventional view, based on the assumption that equity and debt markets are perfectly segmented, suggests that market timing induces a negative relation between equity misvaluation and subsequent changes in leverage ratio. That is, firms with overvalued (undervalued) equity issue more (less) equity, and holding investment opportunities constant, less (more) debt. In this paper, we argue that this view is incomplete, as equity and debt are claims on the same underlying assets. In particular, using price pressure resulting from mutual funds' flow-induced trading to identify equity misvaluation, we show that when equity is overvalued, firms that do not rely on external financing indeed issue more equity and less debt, resulting in a lower leverage ratio. In contrast, firms that are dependent on external financing issue both more equity and debt to sharply increase investment, leading to a slight (albeit insignificant) increase in leverage ratio. In sum, this paper offers a comprehensive analysis of firms' equity and debt financing and investment decisions in response to non-fundamental movements in stock price.