Theseminal work of Baker and Wurgler (2002) sheds a new light on the capitalstructure issue. The authors suggest that it is hard to explain the choice offinancing within the traditional theories. Instead, based on the empiricalfindings of the windows-of-opportunities hypothesis, they propose the markettiming theory, which states that capital structure evolves as the cumulativeoutcome of past attempts to time the equity market. Firms will choose to issueequity when their stocks have high market values relative to their book andpast market value. This lowers the firm’s cost of equity and benefits currentshareholders at the expense of new shareholders. On the other hand, firms willconduct share repurchase in case their stocks are undervalued.
When both debtand equity markets are unusually favorable, managers will raise funds eventhough firm has no need for financing currently. Conversely, in case bothmarkets are unfavorable, firms will defer issuances. This theory also statesthat market timing of equity issues have a very large and persistent impacts onleverage ratio. In particular, temporarily fluctuations in market values causepermanent changes in firms’ capital structure (Nguyen, 2012).
Thereare two versions of the market timing theory. The first one comes from adynamic model of Myers and Majluf (1984), which assumes that managers andinvestors are rational and adverse selection varies across firms or over time.Firms are supposed to issue equity immediately after positive information isreleased which reduces the asymmetric between the managers and shareholders.The decrease in information asymmetry is related to the increase in stock priceand leads to more equity financing. Thus, firms create their own timingopportunities.
The second version of the market timing theory assumes thatmanagers and investors are irrational which results in mispricing perception (Nguyen,2012). According to Baker and Wurgler (2002), managersissue equity when the cost of equity is irrationally low and repurchase equitywhen the costs of is believed irrationally high. The second version does notrequire that the market is inefficient. In fact, the market can still beefficient while managers believe they can time the market.
Both versions ofmarket timing hypothesis have the same predictions about the relationship betweenfirm value and financing decisions. Equity-issuing firms are those with highmarket value relative to book values and those that earn positive abnormalreturns prior to raising capital. To sumup, according to market timing theory, capital structure decisions are takenbased on capital market conditions. Stock prices and interest rate levels aredriving forces for equity and debt issuance decisions respectively (Nguyen,2012).