Market Timing Theory vs Trade Off Theory of the Capital Structure - YouTube

welcome to this audio flip chart on market  timing theory versus trade-off theory of the  

capital structure my name is Manfred Frühwirth  I am professor of finance at WU Wien which is  

Vienna university of economics and business the  purpose of this audio flip chart is to illustrate  

how managers react with the capital structure of  their company after the stock price has gone up  

on this occasion we will contrast the forecast  from the trade-off theory with the forecast from  

the market timing theory and with the actual  decisions that managers make in practice

therefore in this audio flip chart we are  comparing the standard corporate finance view  

the behavioral corporate finance  view and industry practice

first of all what matters  in capital structure theory  

is the capital structure measured at market  values and not the one at book values  

therefore all symbols used in this  audio flip chart represent market values

on the flip chart we use the symbol d  for the volume of debt and the symbol  

v for the total value of the firm which  is the volume of debt and equity together

we see on the horizontal axis the debt ratio which  is the volume of debt divided by the total value  

of the firm so d over v as we are going to the  right we are increasing the financial leverage

the optimal capital structure is the one  that gives the highest business value  

as the business value is determined  by discounting the free cash flows  

and the terminal value with the  weighted average cost of capital  

short WACC the optimal capital structure is also  the capital structure that provides the smallest  

WACC on this flip chart we see the weighted  average cost of capital on the vertical axis

one of the most important and intuitive capital  structure theories in standard corporate finance  

is the trait of theory this theory says  that when selecting the capital structure  

there is a conflict between  taxes and bankruptcy costs

concerning taxes the underlying fact is that debt  interest payments are deducted from the tax base  

so debt interest payments are  creating a so-called tax shield

now when we are increasing the debt ratio  automatically the debt interest payments go up  

and so do the tax shields therefore with a  higher debt ratio our tax burden goes down  

as the WACC includes the tax shield effect you  multiply the cost of debt by 1 minus the tax rate  

the increase in the debt ratio  also brings down the WACC

on the other hand when we  are increasing the debt ratio  

due to the higher volume of debt the  probability of bankruptcy goes up  

and bankruptcy creates inefficiencies these  inefficiencies are called bankruptcy costs  

typical examples of bankruptcy costs are  fees for attorneys or court filing fees  

during the bankruptcy process but there are  also so-called indirect bankruptcy costs  

indirect bankruptcy costs are the  costs of avoiding a bankruptcy filing

the expected bankruptcy costs raise the WACC as a  high volume of debt makes bankruptcy more likely  

this happens especially in the range of large  debt ratios so on the right hand side of the chart

the optimal capital structure is  the one that optimally balances  

the positive tax shield effect and  the negative bankruptcy cost effect  

on the flip chart the optimal capital  structure is marked by an asterisk

compared to the optimal capital structure  if the firm is using a lower debt ratio  

then it could reduce the WACC by borrowing  more and ensuring higher tax shields in that  

case the benefit from higher tax shields exceeds  the damage from higher expected bankruptcy costs

if however the firm is using a higher debt  ratio than with the optimal capital structure  

then it is already in the area where the higher  expected bankruptcy costs from additional debt  

exceed the benefits from higher tax shields  

therefore by reducing the debt ratio  the firm could decrease the WACC

now let us imagine that this company originally  has selected the optimal capital structure  

so the managers are using the  debt ratio d over v as the risk

let us also imagine that after the  choice of the optimal capital structure  

the stock price of that company goes up

this of course increases the market capitalization  of that firm which is the market value of equity  

and thereby also the total value of the firm  however the volume of debt is unaffected  

as a result the market value equity ratio goes  up and the market value debt ratio goes down  

so on our flip chart this stock price increase  automatically shifts the firm to the left  

this is shown by the black arrow

as we can see from the chart this raises the WACC  

the company now has a too small debt ratio and  therefore is losing tax shields compared to the  

optimal capital structure the big question now  is how do the managers react to this situation

according to the trade of theory the answer is  pretty clear the managers immediately have to  

make arrangements in order to re-establish the  optimal capital structure this is part of their  

job in this particular situation this would  mean that they have to increase the debt ratio  

this is shown by the green arrow on the flip chart  

this could easily be done by borrowing money from  the bank or by tapping the bond market and using  

this money in order to buy back their own shares  this would restore the original capital structure  

and bring back the WACC to the original  minimum value as shown in green

now another very intuitive capital structure  theory is the market timing theory of capital  

structure this is a capital structure  theory within behavioral corporate finance  

that has been developed by Malcolm  Baker and Jeffrey Wurgler in 2002

it is interesting to see that the market timing  theory comes to a completely different conclusion

according to the market timing theory the  managers do not re-establish the original  

optimal capital structure by contrast  after the stock price has increased  

they considered their stock now as more  expensive than before and therefore as overvalued

following the market timing goal they rather  issue stocks instead of buying them back  

by this they are moving the capital structure even  further away from the optimal capital structure  

on the flip chart this is shown by the red  arrow and this raises the WACC even more

now the question is which of these two opposing  theories is right if you look into reality  

there are several surveys that show that managers  are very much following the market timing theory  

one example is the study from  Graham Harvey 2001 shown on page two

here we have a table

that includes the answers of the managers to the  question what factors affect your firm's decision  

about issuing common stock

as we can see from this table about 67  of managers indicate as an important  

or very important factor the amount by which our  stock is undervalued or overvalued by the market  

as we can see this is the factor that takes  the second place in the ranking of all factors

in addition more than 60 percent of the managers  say that an important argument for issuing common  

stock is that the stock price has recently  risen and therefore the company can sell stocks  

at a high price so these managers definitely would  not buy back but rather issue new shares after a  

stock price increase thereby they would clearly  violate the prediction of the trade-off theory

another example is provided by the study from  Brav et al 2005 page 3 refers to this study

here the authors analyzed the reasons  

why managers are buying back their  own shares from the capital market

as we can see from this table  86 percent of the managers  

indicated that the stock price was an important  or very important factor in the stock repurchase  

decision managers are buying back their own shares  if they are cheap relative to the true value

so we can assume that these 86 percent of the  managers would not follow the prediction of the  

trade-off theory to buy back shares after the  stock price has increased as mentioned before  

so these two examples show  that the managers in practice  

rather follow the market timing  theory than the trade-off theory

Baker Wurgler 2002 show empirically that  changes in the stock price have a significant  

impact on the capital structure and that it  takes many years until this effect vanishes  

after all the capital structure of  a company at a given point in time  

is the result of the manager's capital  transactions throughout the years before

companies with a low debt  ratio are those companies  

that had to finance externally at times with  a high stock price then they selected equity  

as a financing instrument and the resulting  high equity ratio is kept for many years

by contrast firms with a high debt ratio  are those firms that had to finance at  

times with a low stock price then they  selected debt as a financing instrument  

and the resulting high debt ratio  is maintained for many years

summing up we could see in this audio flip chart  that two very intuitive finance theories lead to  

completely opposing conclusions concerning how  managers react to an increase in the stock price  

the trade of theory concludes that the managers  

will buy back their own  shares from the capital market

by contrast the market timing theory says  that the managers will issue additional shares

also we saw that there is significant empirical  evidence that shows that the market timing theory  

provides a good explanation how managers  determine their capital structure in practice  

i hope you enjoyed this audio flip  chart thank you very much for watching