eThesis - Kauppakorkeakoulun sähköiset gradut

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The most notable capital structure theories today are the traditional pecking order theory, trade-off theory and market timing theory. The first two theories hypothesize a semi-strong efficiency in the capital markets, whereas the market timing theory sees the capital market more or less inefficient. Thus, market timing theory allows the idea of managerial persons to be able to time the market, i.e. issue debt when it is cheap and issue equity when it is cheap. This kind of opportunistic behavior is not allowed by the pecking order or the trade-off theory. But then, why do we witness fluctuations in the general securities issuance behavior in the market?

The prior research has been focusing on explaining this behavior with ex post realized returns but it has been recognized by several studies (e.g., Froot & Frankel, 1989; Gebhardt, Lee, & Swaminathan, 2001; Hou, van Dijk, & Zhang, 2012) that such estimates are extremely noisy. Thus, I will be using a new, more robust measure for cost of capital named implied cost of capital (ICC) which equates the market value of equity and the forecasted future earnings of a given firm in a valuation model. In addition, I will be employing a firm-level ICC.

My data is acquired for U.S. based publicly traded companies for each year from 1974 to 2013. Using financial statement data for a period of minimum six years, I compute my own earnings forecasts applying a regression model introduced by Hou, Van Dijk, and Zhang (2012) and Lee, So, and Wang (2010) as opposed to using analyst forecasts that can biased. After computing the forecasts, apply them to three separate valuation models, and solve for the required market return R (discount rate in the models) which represents the implied cost of capital. These three estimates are used to compute a synthetic implied cost of capital index with equal weights after which it is converted into implied equity risk premium by subtracting the real interest rate.

As a result of my statistical models, I find that firm management follows the level of their firm specific cost of capital and make financing decisions based on this. This behaviour has become even more explicit during the last few years. However, they seem to follow the market-level cost of capital more closely. Changes in the tax rate and growth opportunities seem to also affect the financing behaviour which lends power to the traditional trade-off theory. When testing for the importance of the traditional pecking order theory, it seems to have lost most of its power to explain the securities issuance decisions after the late 1970s.