FEM11118: ADVANCED CORPORATE
FINANCE AND GOVERNANCE
LECTURE 3
MARKET TIMING AND
CONVERTIBLE SECURITIES
,TODAY
Market timing
Can we add to the static tradeoff and pecking order
theory? Discussed in Myers
Convertible security design, reasons for issuing
convertible securities, call policy, and the buyers of
convertible securities
Practice problems on financing decisions
2
,REQUIRED READING
Dutordoir, M., C. Lewis, J. Seward, and C.
Veld, 2014. What we do and do not know
about convertible bond financing. Journal of
Corporate Finance 24, 3-20. ‘overview article’
Points discussed in class are important for exam, other materials from paper
are just for additional background information and overview
3
,STATIC TRADEOFF THEORY
Trade-off between tax shields and the costs of
financial distress
Different firms have different optimums
Nowadays the
trade-off typically
includes agency
costs
Asset substitution, agency cost (disadvantage
of debt)
=Equity holders will take on risky projects
(risk shifting) when close to bankruptcy Firms in same industry usually have same (debt) targets
Prediction: we always want to move towards the optimum
4
, 3:20
PECKING ORDER THEORY
Because of information asymmetry, managers do not
want to issue equity if alternatives are available
There is a financing hierarchy:
1. Internal funds Cares a lot about info asymmetry (there is non with internal funding)
2. Debt Because of tax shield
3. Hybrid securities Debt and Equity characteristics
4. Equity issue Info asymmetry (equity issue bad sign)
5
,Third theory of capital structuring 4:50
Random walk on wallstreet, book (own interest)
MARKET EFFICIENCY
Can prices be wrong? Liquid markets - are pretty efficient, but not perfect
—> Historically: markets have been wrong (bubbles)
Managerial perceptions
They could have more information manager knows more than the market
—> decide on issuing equity / debt
But they could also have biases Overconfidence (=behavioral bias)
especially CEO’s
In their survey of CFOs, Graham and Harvey (2001) find
that over 60% of CFOs find the magnitude of equity
over- or undervaluation important for their decision on
issuing common stock —> equity valuation matters!
6
, 11:44
MARKET TIMING
A relatively simple theory
Maximise current shareholders’ wealth, by:
Issue equity when stock prices are high
Repurchase equity when stock prices are low
“Windows of opportunity”
Consistent pursuit of timing strategies would make debt ratios depend on paths of past stock prices as well
as on requirements for external funds.
Ritter (2003) calls this the “windows of opportunity” theory. If investors sometimes overprice issuing
firms’ shares, so that equity is truly cheap, then equity can move temporarily to the top of the pecking
order.
Thus the windows of opportunity theory could absolve the pecking order of a major empirical shortcoming,
provided that one is willing to assume systematic mispricing of new issues, at least in “hot” issue periods.
7
, MARKET TIMING: EVIDENCE
Stock price run-up matters when predicting debt versus
equity issues and repurchases
Remember the tests from lecture 1?
Debt or Equity issue: a + b1 * deviation target + b2 * runup + E runup = price change past two years
Pre-issue performance: On average, very high stock
returns
Alternative explanation: lot of
growth opportunities / value
that can be materialized, firms
needs financing and issue
equity
8
, 17:30
POST-ISSUE STOCK PRICE PERFORMANCE
Compared to benchmark equity issuing firm dont outperform peers.
Equity offering firms underperform
Loughran and Ritter (1995)
Seasoned Equity
Offering: you already
have issued equity (after
IPO)
9
, 19:20
PERSISTENCE OF MARKET TIMING EFFECT ON
CAPITAL STRUCTURE
Market timing does not seem a complete theory of
capital structure with
Still, it has conditional predictions. If we look at todays debt ratios (firm
high valuation in the past) Listen back recordings (26:30)
it has a very conditional form
Market timing matters but other theories also count
Can we predict firms’ capital structure based on
fluctuations of market values in the past?
If we can closely predict this, then apparently firms do
not move back to their supposed target debt ratio
Most empirical evidence shows that market timing
matters, but the other theories are still useful
10
FINANCE AND GOVERNANCE
LECTURE 3
MARKET TIMING AND
CONVERTIBLE SECURITIES
,TODAY
Market timing
Can we add to the static tradeoff and pecking order
theory? Discussed in Myers
Convertible security design, reasons for issuing
convertible securities, call policy, and the buyers of
convertible securities
Practice problems on financing decisions
2
,REQUIRED READING
Dutordoir, M., C. Lewis, J. Seward, and C.
Veld, 2014. What we do and do not know
about convertible bond financing. Journal of
Corporate Finance 24, 3-20. ‘overview article’
Points discussed in class are important for exam, other materials from paper
are just for additional background information and overview
3
,STATIC TRADEOFF THEORY
Trade-off between tax shields and the costs of
financial distress
Different firms have different optimums
Nowadays the
trade-off typically
includes agency
costs
Asset substitution, agency cost (disadvantage
of debt)
=Equity holders will take on risky projects
(risk shifting) when close to bankruptcy Firms in same industry usually have same (debt) targets
Prediction: we always want to move towards the optimum
4
, 3:20
PECKING ORDER THEORY
Because of information asymmetry, managers do not
want to issue equity if alternatives are available
There is a financing hierarchy:
1. Internal funds Cares a lot about info asymmetry (there is non with internal funding)
2. Debt Because of tax shield
3. Hybrid securities Debt and Equity characteristics
4. Equity issue Info asymmetry (equity issue bad sign)
5
,Third theory of capital structuring 4:50
Random walk on wallstreet, book (own interest)
MARKET EFFICIENCY
Can prices be wrong? Liquid markets - are pretty efficient, but not perfect
—> Historically: markets have been wrong (bubbles)
Managerial perceptions
They could have more information manager knows more than the market
—> decide on issuing equity / debt
But they could also have biases Overconfidence (=behavioral bias)
especially CEO’s
In their survey of CFOs, Graham and Harvey (2001) find
that over 60% of CFOs find the magnitude of equity
over- or undervaluation important for their decision on
issuing common stock —> equity valuation matters!
6
, 11:44
MARKET TIMING
A relatively simple theory
Maximise current shareholders’ wealth, by:
Issue equity when stock prices are high
Repurchase equity when stock prices are low
“Windows of opportunity”
Consistent pursuit of timing strategies would make debt ratios depend on paths of past stock prices as well
as on requirements for external funds.
Ritter (2003) calls this the “windows of opportunity” theory. If investors sometimes overprice issuing
firms’ shares, so that equity is truly cheap, then equity can move temporarily to the top of the pecking
order.
Thus the windows of opportunity theory could absolve the pecking order of a major empirical shortcoming,
provided that one is willing to assume systematic mispricing of new issues, at least in “hot” issue periods.
7
, MARKET TIMING: EVIDENCE
Stock price run-up matters when predicting debt versus
equity issues and repurchases
Remember the tests from lecture 1?
Debt or Equity issue: a + b1 * deviation target + b2 * runup + E runup = price change past two years
Pre-issue performance: On average, very high stock
returns
Alternative explanation: lot of
growth opportunities / value
that can be materialized, firms
needs financing and issue
equity
8
, 17:30
POST-ISSUE STOCK PRICE PERFORMANCE
Compared to benchmark equity issuing firm dont outperform peers.
Equity offering firms underperform
Loughran and Ritter (1995)
Seasoned Equity
Offering: you already
have issued equity (after
IPO)
9
, 19:20
PERSISTENCE OF MARKET TIMING EFFECT ON
CAPITAL STRUCTURE
Market timing does not seem a complete theory of
capital structure with
Still, it has conditional predictions. If we look at todays debt ratios (firm
high valuation in the past) Listen back recordings (26:30)
it has a very conditional form
Market timing matters but other theories also count
Can we predict firms’ capital structure based on
fluctuations of market values in the past?
If we can closely predict this, then apparently firms do
not move back to their supposed target debt ratio
Most empirical evidence shows that market timing
matters, but the other theories are still useful
10
