WHICH VERSION OF THE EQUITY MARKET TIMING AFFECTS CAPITAL STRUCTURE, PERCEIVED MISPRICING OR ADVERSE SELECTION? Abdelaziz Chazi, BS, MBA

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1 WHICH VERSION OF THE EQUITY RKET TIING FFECTS CPITL STRUCTURE, PERCEIVED ISPRICING OR DVERSE SELECTION? bdelaziz Chazi, S, Disseraion Prepared for he Degree of DOCTOR OF PHILOSOPHY UNIVERSITY OF NORTH TEXS ugus 004 PPROVED: Niranjan Tripahy, Commiee Chair James Conover, Commiee ember azhar Siddiqi, Commiee ember Vicor R. Prybuok, Direcor of he College of usiness dminisraion Docoral Program ichael K. raswell, Chair of he Deparmen of Finance, Insurance, Real Esae and Law Sandra L. Terrell, Dean of he Rober.Toulouse School of Graduae Sudies

2 Chazi, bdelaziz, Which version of he equiy marke iming affecs capial srucure, perceived mispricing or adverse selecion? Docor of Philosophy (Finance), ugus 004, 07 pp., 3 ables, references, 8 iles. aker and Wurgler (00) define a new heory of capial srucure. In his heory capial srucure evolves as he cumulaive oucome of pas aemps o ime he equiy marke. aker and Wurgler exend marke iming heory o long-erm capial srucure, bu heir resuls do no clearly disinguish beween he wo versions of marke iming: perceived mispricing and adverse selecion. The main purpose of his disseraion is o empirically idenify he relaive imporance of hese wo explanaions. Firs, I rees aker and Wurgler s heory by using insider rading as an alernaive o marke-o-book raio o measure equiy marke iming. I also formally es he adverse selecion model of he equiy marke iming: firs by using pos-issuance performance, and hen by using hree measures of adverse selecion. The firs wo measures use esimaes of adverse informaion coss based on he bid and ask prices, and he hird measure is based on he close-o-offer reurns. ased on received heory, a dynamic adverse selecion model implies ha higher adverse informaion coss lead o higher leverage. On he oher hand, a naïve adverse selecion model implies ha negaive inside informaion leads o lower leverage. The resuls are consisen wih he equiy marke iming heory of capial srucure. The resuls also indicae ha a naïve, as opposed o a dynamic, adverse selecion model seems o be he bes explanaion as o why managers ime equiy issues.

3 CONTENTS LIST OF TLES. iii Chaper. INTRODUCTION LITERTURE REVIEW Capial Srucure Theory arke Timing Theory of Capial Srucure Financing Decisions and dverse Selecion 3. HYPOTHESES DEVELOPENT DT ND RESERCH ETHODOLOGY..38 Daa and Summary Saisics Research ehodology 5. RESULTS DISCUSSION CONCLUSION PPENDIX REFERENCES ii

4 TLES TLE Page. Opimal Capial Srucure Theory and Informaion symmery Summary of Hypoheses and ehodology Summary Saisics of Capial Srucure and Financing Decisions-ll firms Frequency Disribuion of Equiy Issues Deerminans of nnual Change in Leverage and Insider Trading Correlaion beween arke-o-ook and Insider Trading Deerminans of Leverage and Insider Trading Correlaion beween nnual Change in leverage and Subsequen Performance Leverage and dverse Selecion arke Timing Leverage, Performance, and dverse Selecion arke Timing Leverage and ispricing ased arke Timing Correlaion beween easures of dverse Selecion Correlaion beween arke-o-ook and easures of dverse Selecion Deerminans of nnual Change in Leverage and dverse Selecion Componen of he Spread: odel I Deerminans of nnual Change in Leverage and dverse Selecion Componen of he Spread: odel II..80 iii

5 6. Componens of nnual Change in Leverage and dverse Selecion Componen of he Spread: odel I Componens of nnual Change in Leverage and dverse Selecion Componen of he Spread: odel II Leverage, Subsequen Performance, and dverse Componen of he Spread: odel I Leverage, Subsequen Performance, and dverse Componen of he Spread: odel II Deerminans of Leverage and Underpricing.87. Leverage and dverse Selecion Componen of he Spread: odel I Leverage and dverse Selecion Componen of he Spread: odel II Leverage, Size, and dverse Selecion Componen of he Spread: odel I Leverage, Size, and dverse Selecion Componen of he Spread: odel II 9 5. Leverage, Subsequen Performance, and dverse Componen of he Spread: odel I 9 6. Leverage, Subsequen Performance, and dverse Componen of he Spread: odel II Leverage and dverse Selecion Componen of he Spread: odel I Leverage and dverse Selecion Componen of he Spread: odel II Leverage and dverse Selecion Componen of he Spread: odel I Leverage and dverse Selecion Componen of he Spread: odel II Deerminans of Leverage I Deerminans of Leverage II 0 iv

6 CHPTER INTRODUCTION firm s capial srucure is is mix of differen forms of financing. The goal of a capial srucure policy is o find he combinaion of securiies ha would maximize firm value. Several heories such as he saic radeoff, he pecking order, and he managerial enrenchmen heory ry o address he issue of he moivaions behind managers choice of a given capial srucure. aker and Wurgler (00) (hereafer W) define a new heory of capial srucure. In his heory, capial srucure evolves as he cumulaive oucome of pas aemps o ime he equiy marke. To es heir hypoheses, W use he exernal finance weighed-average marke-obook raio. This variable, which is supposed o measure hisorical variaions in he marke-obook, is found o have a sronger relaionship wih leverage han he conemporaneous marke-obook. ccording o W, managers sysemaically ime equiy issues when marke-o-book levels are high. Therefore, here should be a negaive relaionship beween he hisorical measure of variaions in he marke-o-book raio and leverage. However, here may be wo moives behind marke iming: perceived mispricing and/or adverse selecion. In a es of he perceived mispricing model, auhors such as Lucas and cdonald (990), La Pora e al. (997), and Shleifer (000) documen ha managers issue equiy when hey hink ha is cos is irraionally low, and repurchase when hey hink he cos is irraionally high. This model implies irraional managers and/or invesors, and ime-varying mispricing process. There - -

7 may no be acual mispricing, bu managers ac as if hey hink here is one. Hence, even hough he marke efficiency assumpion sill holds, managers behave like echnical analyss. Therefore, he perceived mispricing explanaion suggess a negaive relaionship beween leverage and marke-o-book. The adverse selecion heory, which is a dynamic version of yers and ajluf (984), is derived assuming raional managers and invesors bu varying adverse selecion coss. These coss can vary across firms or across ime. dverse selecion is shown o influence financing decisions a he corporae level (Korajczyk e al. (99)) and a he marke level (ayless and Chaplinsky (996)). Korajczyk e al. (99) find ha informaion releases have an effec on he pricing and iming of equiy issues. ayless and Chaplinsky (996) show ha managers iming of equiy issues are negaively relaed over ime o he aggregae levels of informaion asymmery in he marke. However, when managers have inside informaion, hey will also have an incenive o sell equiy when hey know ha i is overvalued. This supposes ha he inside informaion managers have ouweighs he negaive signal ha accompanies equiy issues. This naïve version as well as he dynamic version of he adverse selecion heory also implies a negaive relaionship beween leverage and marke-o-book raio. I is hus no clear wheher he negaive relaionship beween leverage and marke-obook ha W aribue o marke iming is due o perceived mispricing or o adverse selecion. The objecive of his research is o empirically examine he long-erm influence of adverse selecion and perceived mispricing on capial srucure. I hope o be able o idenify clearly he primary moive underlying he relaionship beween equiy marke iming and capial srucure. - -

8 Chaper surveys he capial srucure and adverse selecion heories. Firs, capial srucure heories and oher deerminans of capial srucure are presened. Second, marke iming heory of capial srucure is inroduced. Finally, a deailed lieraure survey of financing decisions and adverse selecion is provided. Chaper 3 develops he esable hypoheses. I sar he chaper by using insider rading as an alernaive measure o es for he marke iming heory. Subsequen performance is also used in reesing marke iming heory. Nex, various measures of adverse selecion are presened, as well as heir correlaions wih each oher and wih marke-o-book. series of ess analyzing he shor-erm relaionship beween he change in leverage, and is componens, and adverse selecion are proposed. Lasly, he long-erm relaionship beween leverage and he weighed average adverse selecion is examined using a series of regression analyses. size effec es is presened a he end of he analysis. Chaper 4 describes he daa and also describes how he hypoheses are esed. The sample comes from Sandard & Poor s COPUSTT (Norh merica) daa and covers he period The sample is resriced o firms wih a minimum book value of asses of $0 million. I also excludes financial firms and firm-year ouliers. When bid and ask prices are used, he sample consiss of firms from Compusa for which I could mach he daa wih he bid-ask spread, price, and volume daa from CRSP. Insider rading and holdings daa come from he Ownership Reporing Sysem (ORS) apes. Informaion on monhly reurns is obained from CRSP. The equiy issues daa come from he SEC s Regisraions and Offering Saisics (ROS) daa apes. Chaper 5 presens he resuls. The firs se of resuls peraining o he rees of he equiy marke iming heory provides suppor for he heory. Ne insider selling, as an alernaive o he - 3 -

9 marke-o-book raio by aker and Wurgler (00), is negaively relaed o he change in leverage and posiively relaed o marke-o-book. Weighed average ne insider selling is negaively relaed o he deb raio. These resuls suppor W s equiy marke iming heory of capial srucure. I also find a small bu posiive correlaion beween he change in leverage and subsequen performance, for companies ha issue equiy and are ne insider sellers. Dummy variables based on sub-groups of he laer companies ha eiher consisenly under-perform he mached conrol porfolio or rank a he lowes deciles on subsequen performance are negaively relaed o he deb raio. This resul suppors he naïve version of he adverse selecion model based equiy marke iming. I suggess ha managers issue equiy when i is overpriced based on inside informaion. These equiy iming issues are hus refleced in he long-erm leverage raios. The second se of resuls concerns he dynamic adverse selecion heory of equiy marke iming. I use hree proxies for adverse selecion in my ess: close-o-offer reurns and wo measures of he adverse selecion componen of he bid-ask spread. I show ha here is a small bu posiive correlaion beween marke-o-book and adverse selecion. I also find ha he change in leverage is negaively relaed o he adverse selecion componen of he spread. These laer relaionships come mainly from he ne equiy issues componen of he change in leverage. Finally, using muliple regressions wih differen proxies for adverse selecion, he resuls are inconclusive. The mixed resuls do no suppor he dynamic adverse selecion version of he iming heory. In chaper 6, I discuss he resuls and presen an argumen for he naïve version of he adverse selecion moive underlying marke iming heory. company may choose o issue equiy only o build slack; especially when managers know ha, based on inside informaion, - 4 -

10 equiy is overvalued. Wih no arge opimal capial srucure, managers do no appear o rebalance o opimal levels of deb afer iming he marke. This causes he equiy issues decisions o have a permanen effec on he leverage raio

11 CHPTER LITERTURE REVIEW Capial Srucure Theory The firm s mix of differen forms of long-erm financing is known as is capial srucure. The goal of a capial srucure policy is o find he combinaion of securiies ha would maximize firm value. Several heories ry o address he issue of he moivaions behind managers choice of a given capial srucure and wheher here is an opimal capial srucure. Tradeoff heory The modern heory of capial srucure sars wih he work of odigliani and iller (958). They conclude ha capial srucure has no effec on firm value in perfec capial markes wih no axes. However, odigliani and iller (963) find ha here is a difference beween he value of a levered firm and ha of an unlevered firm. This difference is he value of he ineres ax shield. The value of a levered firm increases wih he level of ineres on he deb i carries. This resul suggesed ha managers should seek 00% deb as he opimal leverage o maximize he corporae value. When we ake ino consideraion marke imperfecions, he radeoff heory suggess ha an opimum leverage can be reached by considering no only axes, bu also imperfecions, such as coss of financial disress and agency coss. The radeoff heory suggess ha firms would seek more deb as long as he presen value of he ax shield is greaer han he presen value of bankrupcy, agency, and all oher coss associaed wih higher leverage

12 gency coss n agency relaionship is one in which one or more owners (principals) delegae he managemen responsibiliies o managers (agens) because of a lack of ime or skills. The goal of each one of hese eniies is self-profi maximizaion. However, principals canno maximize heir profis wihou he help of agens, and agens profi objecives may no coincide wih he principals ; herefore, agency problems arise. oreover, bondholders, who see managers as acing exclusively in he bes ineress of shareholders, ry o proec heir expeced income sream by prevening managers from engaging in high uncerainy projecs. Iniially his heory developed by Jensen and eckling (976), yers (977), and Jensen (986). Jensen and eckling s (976) sudy comes up wih a closed-form soluion o opimal leverage, yers s (977) sudy equaes shareholders ownership o a call opion, and Jensen s (986) free cash flow lead o an opimal amoun of leverage. Jensen and eckling (976) define agency coss as he sum of () monioring coss, () bonding coss, and (3) residual loss. onioring coss are hose coss incurred by he principals in heir effor o monior managemen. onding coss are hose incurred by managemen in heir effors o show heir good inenions o he principals. The res is he residual loss. firm is a home o agency problems beween shareholders and managers, beween shareholders and bondholders, and beween bondholders and managers. ondholders, as ulimae owners of he firm in case of bankrupcy, insis on bonds covenans in which hey ry o preven any aemp by managers o ac in he sole ineres of he shareholders. They have a endency o make managers ake only safe projecs even if he reurn is low, while shareholders may some imes prefer highreurn, high-risk projecs

13 In he case of an all equiy firm, here are no agency coss of deb, and managers would ac solely in he bes ineres of he shareholders. Furhermore, he shareholders are no as emped by risk as hey would be in he presence of bondholders. ll heir ineres is in high ne presen value projecs. gency coss of equiy increase as new shares are sold o ouside shareholders. New shareholders will incur monioring coss o ensure ha old shareholders (owner-shareholders) ac in he bes ineres of all shareholders. s deb is sold and leverage increases, agency coss of deb also increase, while he proporion of equiy, and agency coss of equiy, decreases. The resul is a decrease in he oal agency coss. Jensen and eckling argue ha here is an opimum amoun of leverage ha would be associaed wih a minimum amoun of oal agency coss. subsanial porion of he value of a firm is composed of inangible asses, in he form of fuure invesmen opporuniies. yers (977) shows ha if he shareholders claim on he asses of a levered firm is similar o a call opion, hen shareholders have an incenive o underake riskier projecs because heir call opion value is greaer when he asses of he firm have higher variance. If a firm wih long-erm, risky ousanding deb underakes posiive NPV projecs, shareholders will no be able o capure he full benefis because par of he value goes o deb holders in he form of a reducion on he probabiliy of defaul. yers, herefore, predics ha firms wih high levels of informaion asymmery will suffer from underinvesmen. Jensen (986) defines free cash flow as hose cash flows in excess of wha is required for funding all projecs ha have posiive NPV when discouned a he relevan cos of capial. anagers have incenives o cause heir firms o grow beyond he opimal size. Growh increases managers power by increasing he resources under heir conrol. Deb reduces he agency coss of free cash flow by reducing he amoun of cash under managemen conrol. The opimal deb

14 equiy raio is he poin a which firm value is maximized, he poin where marginal coss of deb jus offse he marginal benefis. Secured deb os auhors of capial srucure lieraure argue ha he ype of asses owned by a firm affecs is capial srucure choice, parly because of bankrupcy coss. Sco (976) shows ha opimal leverage is relaed o secured deb because he laer is collaeralized by angible asses. He argues ha firms wih asses ha can be used as collaeral may be expeced o issue more deb since in case of bankrupcy any losses o bondholders are limied. Suppor for his heory is provided by yers and ajluf (984). They show ha, under asymmeric informaion, firms may find i advanageous o sell secured deb because issuing equiy is cosly. Since managemen is supposed o have beer informaion abou earnings prospecs, ouside invesors prefer o inves in deb backed by secured asses. lso, as suggesed by yers (977), shareholders have an incenive o induce managers o inves in high risk projecs which will increase heir call value. Since collaeralized deb can only be used for he inended purpose, a posiive relaionship will exis beween deb raios and he capaciy of firms o collaeralize heir deb. s deb is collaeralized, bondholders fear less he expropriaion of heir wealh by shareholders. This can reduce he underinvesmen problem. Pecking order heory s a subsiue o he heory of radeoff beween ax shield, financial disress and agency coss, he pecking order heory explains capial srucure in erms of managemen choice of financing in response o asymmeric informaion. The heory does no suppor he exisence of an opimal capial srucure

15 yers (984) argues ha because of asymmeric informaion, companies will prefer o use heir reained earnings o finance growh opporuniies. If furher financing is required, preference will be given o secured deb firs, hen converible deb, and hen equiy. yers and ajluf s (984) assumpions are as follows:. anagers, beer han anyone else, are assumed o know he rue fuure value of he firm.. Furhermore, hey are assumed o ac in he ineres of old shareholders who are assumed o be passive. Under he pecking order heory, whenever a firm needs financing, i would sar by using all is reained earnings and hen is deb capaciy. firm wih enough slack does no need o go o he capial marke for financing. However, a firm wih oo much slack would fall under Jensen s free cash flow problem. anagers canno reain big amouns of cash wihou disbursing i. They are urged by shareholders eiher o inves free cash flow or pay i as dividends. Once slack is used, a firm would urn o deb financing. anagers use all heir deb capaciy before issuing socks. dynamic version of yers and ajluf (984) is behind he presen research of capial srucure and adverse selecion, and will be sudied in more deail in he following secions. anagerial enrenchmen heory anagerial enrenchmen is one of he heories proposed, by several auhors, o explain capial srucure. Proponens of his heory argue ha subjecive reasons may deermine leverage choices made by managers. However, differen conclusions are drawn by grawal and andelker (987), and ehran (99) on one hand, and Friend and Lang (988), and erger, Ofek, and Yermack (997) on he oher hand

16 grawal and andelker (987) sugges ha he securiy holdings of managers of firms wih a deb-equiy raio ha increases are larger han hose for which his raio decreases. lso, when managers make financing decisions, execuive securiy holdings have a preponderan role in reducing agency problems. Consisen wih he predicions of he agency heory, ehran (99) finds a posiive relaionship beween he firm s leverage raio and he percenage of he following: ) Execuives oal compensaion in incenive plans. ) anagers owned equiy. 3) Invesmen bankers on he board of direcors. 4) Large individual invesors owned equiy. On he oher hand, Friend and Lang (988) show ha he level of deb decreases as he level of managemen invesmen (shareholding) in he firm increases. This finding is independen of he exisence of any kind of non-managerial principal sockholders. These are assumed in Friend and Lang s sudy o have sufficien invesmen in he firm o warran he effor required for monioring and o influence managemen appropriaely. oreover, when corporaions have large non-managerial invesors, he average deb raio is significanly higher han in hose wih no principal sockholders. This resul suggess ha he exisence of large non-managerial sockholders migh make he ineress of managers and public sockholders coincide. erger e al. (997) find evidence ha firm leverage is affeced by he degree of managerial enrenchmen, and ha enrenched managers seek o avoid deb. They find ha leverage is lower when he CEO has a long enure in office, has weak sock and compensaion incenives, and does no face srong monioring from he board of direcors or major sockholders. - -

17 anagers can use leverage o inflae he voing power of heir equiy as suggesed by Sulz (988). When firms are arges of ender offers, i is argued ha enrenched managers use leverage as a defensive device o buy ime for he implemenaion of heir own resrucuring program insead of he ouside raider s. The lieraure on mergers and acquisiions offer several siuaions in which agency coss increase because of managers self ineress. On he effec of managerial incenives o bear risk on capial srucure, Nam, Ooo, and Thornon (003) find ha as he CEO s sensiiviy o sock-reurn volailiy increases, he firm chooses higher deb raios. CEO s wih low sensiiviy o sock-reurn volailiy choose lower deb raios. Nam e al. argue ha when firms have relaively low ouside monioring, managerial incenives o bear risk play a sronger role in deermining he level of deb in heir capial srucure. The degree of ouside monioring, hus, aenuaes he relaionship beween managers sensiiviy o reurn volailiy and he degree of financial leverage. Uncerainy and risk managemen any auhors argue ha here is an inverse relaionship beween opimal deb level and he volailiy of earnings. Sulz (996), Ross (997), and Leland (998) show ha, by reducing he volailiy of income, hedging increases deb capaciy. However, couner-examples o his basic hypohesis have also been demonsraed by auhors such as Casanias and Dengelo (98) and radley, Jarrell, and Kim (984). The basic model underlying hese papers was firs inroduced by Leland (994), who was able o develop closed-form soluions for he value of deb and for opimal corporae capial srucure. His resuls indicae ha a rise in he risk-free ineres rae (increasing he cos of deb financing) leads o a greaer opimal deb level. Increasing risk ransfers value from bondholders o sockholders when deb is unproeced, leading cauious bondholders o demand higher - -

18 ineres raes even when he firm currenly has low risk. u such coss ypically are no incurred when firms issue proeced deb. Proeced deb may be he preferred form of financing in hese siuaions. One limiaion of Leland s model is ha i solves for he firm s opimally-levered value, given ha ineres raes are consan and ha he firm issues exclusively infinie mauriy deb. Leland and Tof (996) exend Leland s (994) closed-form resuls o a much richer class of possible deb srucures and permi he sudy of he opimal mauriy of deb as well as he opimal amoun of deb. They show ha opimal leverage depends upon deb mauriy, and i is noiceably lower when he firm is financed by shorer-erm deb. The fac ha longer-erm deb generaes higher firm value poses he quesion of why firms issue shor-erm deb. One answer o his quesion, some auhors conend, is ha shor-erm deb reduces agency coss. lso, in he presence of agency coss, i is shown ha riskier firms should issue shorer erm deb in addiion o using less deb. Using Leland s (994) model, Ross (997) shows ha hedging a firm s asses can resul in an enhanced opimal capial srucure ha is worh an exra 0 o 5 percen for curren shareholders. Cross-secional leverage sudies ypically employ measures of earnings variabiliy as proxies for risk in unlevered firms, and hese sudies also implicily assume ha, aside from mean and variance, earnings processes are homogeneous across firms. Raymar (99) suggess ha such measures may be empirically inappropriae. Under he assumpion ha earnings follow an auoregressive process, Raymar argues ha firm value and leverage vary opimally hrough ime and increase wih earnings. The model s primary implicaion is ha he greaer serial correlaion can induce larger han average variabiliy in firm value. This larger variabiliy resuls in lower opimal leverage

19 When earnings are low, a firm opimally would reduce is leverage raio and deb level. In pracice, however, leverage is ypically observed o increase during recessions. This phenomenon migh be explained by increased agency and informaional coss a such imes. lhough derivaives offer only one means for managing risk among many ohers, he relaively low ransacions coss of engaging in derivaives programs make his an ideal seing for researchers o sudy corporae hedging pracices and objecives. One sudy by Graham and Rogers (00) finds evidence ha firms do hedge in order o increase deb capaciy and ineres deducions. This implies ha a complee modeling of corporae deb policy should conrol for he influence of hedging decisions. Failure o do so can resul in serious economerics problems in any regression analysis wih leverage as a dependen variable. Oher deerminans of capial srucure The lieraure on capial srucure offers oher facors ha may affec i. These facors are profiabiliy, asse srucure, growh, abnormal reurns, naional paerns and macroeconomic facors, size, and ownership paerns. Profiabiliy s shown in yers (984) and yers and ajluf (984), because of informaion asymmery in he financial marke place, firms prefer o finance heir projecs firs by he reained earnings, second by deb, and las by equiy. This suggess ha pas profiabiliy, and, consequenly, he amoun of reained earnings available o a firm are imporan facors in is financings decisions. yers (993) shows ha he mos profiable companies borrow he leas. sse srucure Empirical sudies agree ha here are some indusry paerns in capial srucure. ining companies, public accouning firms, and service firms have a low deb-o-equiy raio, while - 4 -

20 uiliies, seel companies, and ransporaion companies carry high leverage. Timan (984) suggess a liquidaion reason for he capial srucure indusry paerns. anufacuring companies, for example, should carry less deb because of cosly liquidaion. Growh Under he agency heory, shareholders ry o expropriae wealh from bondholders by invesing sub-opimally. Green (984) and Smih and Warner (979) argue ha converible deb may be posiively relaed o growh opporuniies. The reason behind his relaionship is ha he use of converible deb reduces agency coss beween equiy holders and bondholders. bnormal reurns Research clearly shows ha he sock marke reacs posiively o a deb increasing issue, and negaively o a leverage decreasing issue. Sock prices rise in response o deb issues more so when firms conrac bank loans, as shown by James (987) and drop in response o seasoned equiy offerings as well as in response o equiy-for-deb exchange offer. Naional paerns and macroeconomic facors There appears o be a relaionship beween deb raios and he firm s counry of origin. Differen counries have differen leverage raios because of hisorical, insiuional, or culural facors. he aggregae level, Rajan and Zingales (995) show ha some facors affecing he leverage rae are he ax code, bankrupcy laws, paerns of ownership, and banks vs. markebased counries. One of he mos recen sudies in his area was conduced by Korajczyk and Levy (00). They spli heir sample based on a measure of financial consrains and found ha arge leverage is couner-cyclical for he relaively unconsrained sample, bu pro-cyclical for he relaively - 5 -

21 consrained sample. The choice of wha ype of securiy o issue/repurchase is significanly relaed o deviaions from he arge capial srucure, paricularly for he consrained sample. Oher resuls sugges ha macroeconomic condiions are significan for issue choice for unconsrained firms bu less so for consrained firms. These resuls suppor he hypohesis ha only unconsrained firms are able o ime heir issue choice o periods when macroeconomic condiions are favorable, while consrained firms ake wha hey can ge. Size Size is also shown o be a major facor deermining he capial srucure. Relaively large firms end o be more diversified and less prone o bankrupcy. Furhermore, he cos of issuing deb and equiy securiies is also relaed o firm size. Smih (977) suggess ha because small firms pay much more han large firms o issue new equiy, and also somewha more o issue long-erm deb, small firms may be more leveraged han larger ones. Small firms may also prefer o borrow shor-erm (hrough bank loans) raher han issue long-erm deb because of he lower fixed coss associaed wih his alernaive. Ownership Paerns Some research poins o he fac ha here is a relaionship beween ownership paerns and leverage raio. os of he auhors agree ha concenraed firms end o suppor more deb han similar public firms. However, Friend and Lang (988) documen ha family-owned firms are much more likely o be all-equiy financed han are non-family-owned companies. arke Timing Theory of Capial Srucure The idea of marke iming evolved afer he work of Loughran and Rier (995), and Spiess and ffleck-graves (995), who found ha firms experience long-erm underperformance afer equiy issues

22 Loughran and Rier (995) find ha he average annual reurn during he five years afer issuing is only 7 percen for firms conducing seasoned equiy offerings. Invesing an equal amoun a he same ime in a non-issuing firm wih approximaely he same marke capializaion, and holding i for an idenical period, would have produced an average compound reurn of 5 percen. Spiess and ffleck-graves (995) sugges ha managers ake advanage of overvaluaion in boh he iniial and seasoned equiy offering markes. Firms making seasoned equiy offerings underperform a sample of mached firms from he same indusry and of similar size ha did no issue equiy. Sein (996) gives suppor o hese findings, and shows ha managers can ime he marke o maximize exising shareholders wealh. ispricing and marke under/over reacion o equiy issues lead managers o acively seek o benefi from marke iming. oreover, aker and Wurgler (000) show ha he share of equiy issues in oal new equiy and deb issues is a srong predicor of U.S. sock marke reurns beween 98 and 997. They argue ha when equiy prices are oo high, exising shareholders benefi by issuing overvalued equiy, and when equiy prices are oo low, issuing deb is preferable. Consequenly wih his iming hypohesis, firms issuing equiy have poor subsequen performance. However, when comparing he abiliy of agency models, pecking order, and iming models o explain firms decisions o issue equiy or deb, Jung, Kim, and Sulz (996) fail o find suppor for he iming heory; raher, hey find srong suppor for he agency model. The firs expansion of he marke iming heory o capial srucure is proposed by aker and Wurgler (00) (W). The heory hey presen saes ha capial srucure evolves as he cumulaive oucome of pas aemps o ime he equiy marke. The auhors use Rajan and Zingales s (995) and Fama and French s (00) deerminans of capial srucure o es for - 7 -

23 marke iming hypohesis. Rajan and Zingales (995) deerminans of capial srucure are marke-o-book, profiabiliy, firm size, and asse angibiliy. W use also four more variables used in Fama and French s (00) sudy of capial srucure deerminans. These variables include wo measures of dividends, a measure of depreciaion, and a measure of research and developmen. The variable of ineres in he W sudy is he marke-o-book value of asses, which can be regarded as a measure of invesmen opporuniies. Hile and Haddad (99) sugges ha marke-o-book value provides an indicaion of asymmeric informaion. When marke values are differen han book values, due o growh opporuniies, informaion asymmery is likely o increase. The auhors find a negaive relaionship beween marke-o-book in year - and leverage in year. High values of marke-o-book are associaed wih less leverage, and low marke-obook values are associaed wih higher raios of deb-o-oal asses. new variable ha is supposed o summarize he hisorical variaion in marke valuaions is added o he oher deerminans of capial srucure. This exernal finance weighed-average marke-o-book raio, for a given year-firm, is defined as follows: efwa, = e s= 0 r= 0 s e d r s d r s Where he summaions are aken saring eiher a he IPO year, or from he firs year of available Compusa daa, and e and d denoe ne equiy and ne deb issues, respecively. The exernal finance weighed-average is economically and saisically significan when used in a mulivariae regression wih leverage as he dependen variable. I is so, even when he one period lagged marke-o-book is included in he regression. The hisorical value is sronger and - 8 -

24 more consisen. es of persisence shows ha he hisorical influence of marke-o-book lass for a leas en years. Jener (003) provides more evidence of marke iming boh a he corporae and managemen level. anagers in low marke-o-book firms purchase equiy on heir own, and repurchase for heir firms. arke iming shows up in managers own porfolios, as well as in he firm s financing decisions. In Jener s analysis, also, marke inefficiency is no implied. Here again, managers are said o be overconfiden in heir abiliy o value heir firms beer han ouside invesors can. High marke-o-book firms are regarded as growh firms and low markeo-book firms are regarded as value firms. anagers end o purchase equiy in value firms and end o sell in growh firms. Jener goes furher in his analysis and saes ha managers may issue equiy only o profi from he believed mispricing, no because of a growh opporuniy or a need for funds. Negaive ne presen values projecs may be underaken only because equiy is believed o be cheap, and posiive ne presen values forgone only because funding is believed o be expensive. Korajczyk and Levy (003) show ha firms, especially financially unconsrained ones, ime heir issues o coincide wih periods of favorable macroeconomic condiions. The crieria for a firm o be labeled financially consrained are: () he firm does no have a ne repurchase of deb or equiy and does no pay dividends wihin he even window, and () he firm s Tobin s Q, defined as he sum of he marke value of equiy and he book value of deb, divided by he book value of asses, a he end of he even quarer should be greaer han one. Oherwise, a firmwindow is labeled financially unconsrained. Leverage of firms in he financially unconsrained sample is shown by Korajczyk and Levy (003) o vary couner-cyclically wih macroeconomic condiions. The macroeconomic - 9 -

25 condiions accoun for % o 5% of he ime-series variaion in hese firms leverage. eanwhile, firms in he financially consrained sample are found o have pro-cyclical leverage, wih macroeconomic condiions accouning for 4% o 4% of he ime series variaion. W conclude ha capial srucure is jus he cumulaive oucome of pas aemps o ime he marke. However, he auhors were no able o definiely discriminae beween he wo versions of marke iming. The perceived mispricing version saes ha managers will issue equiy when hey hink ha is cos is irraionally low and repurchase when hey hink he cos is irraionally high. This version implies irraional managers and/or invesors, and ime-varying mispricing. anagers ac as echnical analyss and hink hey can ime equiy issuance even hough marke may sill be efficien. squih and ullins (986) and Korajczyk, Lucas, and cdonald (99) show ha companies end o issue equiy following unusually large increases in heir sock prices, and hey absain from issuing new equiy in imes of falling sock prices. squih and ullins (986) show ha here is a price run-up preceding equiy issues. They repor ha issues of seasoned equiy are inerpreed as bad news by invesors, wih negaive announcemen dae effecs on equiy prices. This resul is prediced by he hree capial srucure models: pecking order, agency coss, and iming models. oreover, he resuls are indusry specific mainly because of differen levels of informaion asymmery. The second version of marke iming is he adverse selecion version. The nex secion surveys he lieraure on he effec of adverse selecion on financing decisions and marke iming

26 Financing Decisions and dverse Selecion One of he main issues in he financial marke place is ha one pary does no know enough abou he oher pary o be able o engage in ransacions wih i. This informaion asymmery problem was firs sudied by kerlof (970), who was able o relae qualiy and uncerainy. The basic idea is ha here are many markes in which buyers use some marke saisic o judge he qualiy of prospecive purchases. In his case here is incenive for sellers o marke poor qualiy merchandise, since he reurns for good qualiy accrue mainly o he enire group whose saisic is affeced raher han o he individual seller. s a resul, here ends o be a reducion in he average qualiy of goods and also in he size of he marke. There are wo problems creaed by asymmeric informaion; adverse selecion and moral hazard. dverse selecion problems arise before he ransacion occurs. For example, invesors wih bad credi would seek ou loans a any price (marke for lemons). In he case of moral hazard, afer he ransacion occurs, he lender faces he risk ha he invesor will no use he funds for he inended purpose. The marke can collapse if he lenders, because of he fear of adverse selecion or moral hazard problems, decide no o give loans a all. The odigliani-iller heorem on he irrelevancy of capial srucure implicily assumes informaion symmery. However, Ross (977) shows ha if managers possess inside informaion, he choice of managerial financial srucure signals informaion o he marke. The value of firms is argued o rise wih leverage, since increasing leverage increases he marke s percepion of value. In yers and ajluf (984), managers are supposed o know, beer han anyone else, he profi opporuniies of heir firm. Invesors are well aware of his, and hey require more reurn on heir invesmens han managers are willing o offer. ecause managers are supposed o ac in - -

27 he bes ineress of exising shareholders, an equiy issue ends o signal ha managers suspec profi opporuniies o be risky or no good, and hey inend o have ouside invesors share his risk. deb issue, on he oher hand, signals managers confidence abou expeced cash flow and heir abiliy o pay back fixed ineres amouns. symmeric informaion is he key. yers and ajluf poin o he underinvesmen problem ha can arise when managers forego invesmen opporuniies when hey believe ha equiy is undervalued. dynamic version of yers and ajluf (984) assumes ime varying adverse selecion. Choe, asulis, and Nanda (993) show ha firms end o issue seasoned equiy when hey face lower adverse selecion coss. This occurs in periods of more promising invesmen opporuniies and less uncerainy abou asses in place. Sudies by Lucas and acdonald (990) and Korajczyk, Lucas, and cdonald (99) examine adverse selecion ha varies across firms. The decision o issue equiy depends on he degree of managers privae informaion and, ulimaely, on heir willingness o pospone issues unil he privae informaion becomes public. Keser (986) and Chari, Jagannahan, and Ofer (988) show ha informaion asymmery varies wih firm size. Larger firms have less asymmeric informaion han smaller ones. lso Lin and Howe (990) argue ha because smaller firms are no moniored by financial analyss as larger firms are, informaion asymmery is greaer in smaller firms. The choice a firm makes beween financing is invesmens wih equiy or deb depends on several variables including how informed invesors are abou he firm and is earnings prospecs. Gennoe (986) argues ha when selecing heir opimal porfolio, invesors use all available informaion in forming expecaions. Under adverse selecion, a firm issues deb when less informaion is available o he public. The firm may conceive ha he invesor who does no have enough informaion is no likely o ake risks wih is socks, and hence is more willing o - -

28 accep less reurn for less risk by buying deb. How informed an invesor is deermines ulimaely wha ype of securiies he or she is willing o buy. The reurn on equiy is more variable and more sensiive o informaion han fixed reurn deb. Firms ha issue deb benefi from low cos funds. Those ha issue socks, benefi from risk sharing. Veronesi (000), who invesigaes he relaionship beween he precision of public informaion abou economic growh and sock marke reurns, finds ha higher precision of signals ends o increase he risk premium. Researchers use several mehods o accoun for adverse selecion since no one mehod is agreed upon o capure informaion asymmery. uhors such as Dierkens (99) relae informaion asymmery o wo main facors: uncerainy abou he firm in erms of variance of reurns and he informaion relaed measures such as public announcemens. The problem of adverse selecion can make firms lean owards more converible deb financing. Sein (99) explains ha issuing converible deb gives a firm more laiude owards issuing more deb if needed. firm issues converibles, wih a call provision, so ha i could force conversion o equiy when informaion is revealed before deb mauriy. The objecive is o avoid problems associaed wih adverse selecion. es of managers abiliy o ime he marke is provided by Kahle (000). y sudying insider rading around periods of new equiy issues, he auhor is able o show ha insiders ownership changes prior o equiy and converible deb issuance. Kahle (000) finds ha in he six monhs prior o converible deb and equiy issues (informaion revealing securiies), insider sales increase (and purchases decrease). Insider rading is also posiively relaed o sock price run-up and marke-o-book raios. oreover, Kahle finds a negaive relaionship beween abnormal insiders selling and long-run performance for equiy issues, and he finds a posiive - 3 -

29 relaionship beween abnormal purchases and long-run performance for sraigh deb issues. The auhor suggess ha hese resuls are consisen wih managers iming equiy issue as well as heir personal rades. ayless and Chaplinsky (996) show ha managers ime equiy issues in erms of he marke level of informaion asymmery. I is suggesed ha here exis windows of opporuniy for equiy issues resuling from periods of reduced informaion asymmery. Conrary o oher sudies (Choe, asulis, and Nanda (993)) ha base he selecion crieria of issue condiions on macroeconomic variables, ayless and Chaplinsky use he aggregae volume of equiy issues as a deerminan of issue condiions. They rank a hree-monh moving average of equiy issue volume ino quariles. They define HOT issue periods as a leas hree coniguous monhs when equiy volume exceeds he upper quarile. COLD issue periods are defined as a leas hree coniguous monhs when issue volume falls below he lower quarile. NORL issue periods fall beween he upper and lower periods. ayless and Chaplinsky find ho markes offer favorable condiions for issues ha are independen of macroeconomic and marke condiions. Furhermore, he price reacion o equiy issues becomes less negaive a a decreasing rae as issue volume increases. The difference in price reacions beween ho and cold markes is highly economically significan. ayless and Chaplinsky conclude ha ime varying asymmeric informaion is one of he major concerns of invesors when deciding o inves in imes of ho or cold issue markes. Table summarizes he lieraure review secion wih regard o opimal capial srucure and informaion asymmery

30 Table : Opimal Capial Srucure Theory and Informaion symmery Opimal Capial Informaion Theory Srucure: Y/N symmery: Y/N ackground odigliani and iller (963) Jensen and eckling Tradeoff Y N (976) yers (977) Jensen (986) yers (984) Pecking order N Y yers and ajluf (984) grawal and andelker (987) Friend and Lang anagerial N Y (988) enrenchmen ehran (99) erger, Ofek, and Yermack (997) aker and Wurgler arke iming N Y (00) - 5 -

31 CHPTER 3 HYPOTHESES DEVELOPENT aker and Wurgler (00) (W) heorize ha managers ime he marke when hey issue equiy or deb. They argue ha he choice beween hese wo ypes of financing is linked in imporan ways o he raio of he marke o he book value of asses. However, W sae ha marke-o-book can be a proxy for boh he moives of managers percepions of sock under- /over-valuaion and adverse selecion as explanaions of marke iming. W argue ha even if marke-o-book measures managers percepions of sock valuaion, his does no mean ha he marke is inefficien. The marke can sill be efficien while managers hink hey can ime heir issues. High, by hisorical sandards, marke-o-book consiues a signal o managers of a good opporuniy o issue equiy insead of deb. Low marke-o-book leads o more deb issues. Therefore, marke-o-book is expeced o have a negaive relaionship wih leverage. The second argumen of his marke iming heory comes from a dynamic model of yers and ajluf (984), in which adverse selecion varies across ime or firms, and managers and invesors are raional. W argue ha since lower adverse selecion is relaed o higher marke valuaion of asses compared o book values, low adverse selecion leads o more equiy financing. ayless and Chaplinsky (996) show ha equiy issues happen mos ofen in periods of smaller announcemens effecs. Korajczyk, Lucas, and cdonald (99) find ha a firm prefers o issue equiy when he marke is mos informed abou is earnings prospecs. ccording - 6 -

32 o he dynamic adverse selecion model, marke-o-book is also expeced o have a negaive relaionship wih leverage. W find ha marke-o-book is no only relaed o he shor-erm choice of financing, bu i has also a long-erm effec. lag of en years in he marke-o-book raio is found o be saisically significan when regressed on leverage. W conend ha capial srucure evolves as he cumulaive oucome of pas aemps o ime he equiy marke. However, he W sudy is no able o deermine wheher he cumulaive effec of marke iming on capial srucure is primarily due o he moive of perceived mispricing or o he moive of adverse selecion. Nex, I shall use an alernaive iming measure, he level of insider rading, o es he validiy of W s heory. I shall develop a modified version of he W mehodology o examine he shor- and long-erm effecs of insider rading on marke iming. y goal is o deermine wheher adverse selecion or perceived mispricing is he main moive behind he equiy marke iming heory. Hypohesis The level of insider rading, as well as he marke-o-book used by W, can be used o es for he marke iming heory of capial srucure. Kahle (000) finds ha in he six monhs prior o converible deb and equiy issues, insider sales increase and purchases decrease. y sudying insider rading around periods of new equiy issues, Kahle is able o show ha insiders ownership changes prior o equiy and converible deb issuance. The auhor suggess ha hese resuls are consisen wih he managers iming equiy issue as well as heir personal rades. grawal and andelker (987) sugges ha he securiy holdings of managers of firms wih a deb-equiy raio ha increases are larger han hose for which his raio decreases. lso, - 7 -

33 consisen wih he predicions of agency heory, ehran (99) finds a posiive relaionship beween he firm s leverage raio and he percenage of managers owned equiy. Therefore, insider rading, more specifically insider selling, can be used as anoher measure o es for equiy marke iming and capial srucure. Under he perceived mispricing moive, his implies ha managers hink hey can ime equiy issuance using echnical analysis. On he oher hand, managers may also ime he equiy issues based on inside informaion. Insiders sell pars of heir ownership prior o equiy issues if, based on echnical analysis, hey hink he firm is over-valued, or if hey acually have negaive inside informaion abou he earnings prospecs. Inside informaion gives insiders incenives o increase heir holdings of undervalued firms and decrease heir holdings of overvalued firms; hence, equiy issues based on marke iming should be accompanied by increased insiders selling. Hypohesis : There is a negaive relaionship beween he change in leverage and ne insider selling. Hypohesis : There is no or a posiive relaionship beween he change in leverage and ne insider selling. Hypohesis Prior research documens a relaionship beween insider rading and marke-o-book. Kahle (000) finds ha insider rading is posiively relaed o sock price run-up and marke-obook raios. Jener (003) shows ha value firms (low marke-o-book) are regarded as undervalued by heir managers relaive o growh (high marke-o-book) firms. Therefore, we would expec o find a posiive correlaion beween marke-o-book and ne insider selling

34 Hypohesis : There is a posiive correlaion beween marke-o-book and ne insider selling. Hypohesis : There is no or a negaive correlaion beween marke-o-book and ne insider selling. Hypohesis 3 Once he shor-erm relaionship beween ne insider selling and he change in leverage is esed, ne insider selling s long-erm relaionship wih capial srucure can be also esed. The following hypohesis is a modified version of W s heory ha ess ne insider selling as a measure of equiy marke iming. Hypohesis 3: There is a negaive relaionship beween he deb raio and hisorical levels of ne insider selling. Hypohesis 3: There is no or a posiive relaionship beween he deb raio and hisorical levels of ne insider selling. Hypohesis 4 anagers can issue equiy for wo reasons. The firs is ha hey acually need exernal financing a a ime when he sock price is excepionally high, and/or he level of informaion asymmery is excepionally low. This makes equiy issue an aracive decision over deb issue. The second reason for an equiy issuance is ha managers hink hey can profi from his siuaion, as heir perceived abnormally overvalued firm may experience low growh opporuniies in he fuure, or because of informaion asymmeries beween insiders and ousiders. In his case he main objecive behind he issue is no o finance a projec, bu o benefi from a special siuaion in he marke place. Under he perceived mispricing version, and based on echnical analysis, he sock price is supposed o have reached a peak ha would be followed by a price drop. Under he dynamic adverse selecion version, managers issue equiy in - 9 -