Hostname: page-component-7c8c6479df-r7xzm Total loading time: 0 Render date: 2024-03-28T15:59:34.977Z Has data issue: false hasContentIssue false

Equity Mispricing and Leverage Adjustment Costs

Published online by Cambridge University Press:  17 January 2012

Richard S. Warr
Affiliation:
Poole College of Management, North Carolina State University, Box 7229, Raleigh, NC 27695rswarr@ncsu.edu
William B. Elliott
Affiliation:
Department of Economics and Finance, University of Texas at El Paso, 500 W University Ave, El Paso, TX 79968wbelliott@utep.edu
Johanna Koëter-Kant
Affiliation:
Faculty of Economics and Business Administration, VU University Amsterdam, De Boelelaan 1105, Amsterdam 1081 HV, The Netherlands Koëter-Kant, jkoeter@feweb.vu.nl
Özde Öztekin
Affiliation:
College of Business Administration, Florida International University, 11200 SW 8th St, Miami, FL 33199. ozde@fiu.edu

Abstract

We find that equity mispricing impacts the speed at which firms adjust to their target leverage (TL) and does so in predictable ways depending on whether the firm is over- or underlevered. For example, firms that are above their TL and should therefore issue equity (or retire debt) adjust more rapidly toward their target when their equity is overvalued. However, when a firm is undervalued but needs to reduce leverage, the speed of adjustment is much slower. Our findings support the role of equity mispricing as an important factor that alters the cost of making capital structure adjustments.

Type
Research Articles
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Alti, A.How Persistent Is the Impact of Market Timing on Capital Structure?Journal of Finance, 61 (2006), 16811710.Google Scholar
Baker, M., and Wurgler, J.. “Market Timing and Capital Structure.Journal of Finance, 57 (2002), 132.Google Scholar
Blundell, R., and Bond, S.. “Initial Conditions and Moment Restrictions in Dynamic Panel Data Models.Journal of Econometrics, 87 (1998), 115143.Google Scholar
Butler, A. W.; Cornaggia, J.; Grullon, G.; and Weston, J. P.. “Corporate Financing Decisions, Managerial Market Timing, and Real Investment.Journal of Financial Economics, 101 (2011), 666683.Google Scholar
Byoun, S. “How and When Do Firms Adjust Their Capital Structures toward Targets?Journal of Finance, 63 (2008), 30693096.CrossRefGoogle Scholar
Chang, X., and Dasgupta, S.. “Target Behavior and Financing: How Conclusive Is the Evidence?Journal of Finance, 64 (2009), 17671796.Google Scholar
Chen, L., and Zhao, X.. “Mechanical Mean Reversion of Leverage Ratios.Economics Letters, 95 (2007), 223229.Google Scholar
D’Mello, R., and Shroff, P. K.. “Equity Undervaluation and Decisions Related to Repurchase Tender Offers: An Empirical Investigation.Journal of Finance, 55 (2000), 23992425.Google Scholar
Dong, M.; Hirshleifer, D.; Richardson, S.; and Teoh, S. H.. “Does Investor Misvaluation Drive the Takeover Market? “ Journal of Finance, 61 (2006), 725762.Google Scholar
Elliott, W. B.; Koëter-Kant, J.; and Warr, R. S.. “A Valuation-Based Test of Market Timing.Journal of Corporate Finance, 13 (2007), 122128.Google Scholar
Elliott, W. B.; Koëter-Kant, J.; and Warr, R. S.. “Market Timing and the Debt-Equity Choice.Journal of Financial Intermediation, 17 (2008), 175197.Google Scholar
Fama, E. F., and French, K. R.. “Industry Costs of Equity.Journal of Financial Economics, 43 (1997), 153193.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Testing the Trade-Off and Pecking Order Predictions about Dividends and Debt.Review of Financial Studies, 15 (2002), 133.Google Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.Journal of Political Economy, 81 (1973), 607636.Google Scholar
Faulkender, M.; Flannery, M.; Hankins, K.; and Smith, J.. “Are Adjustment Costs Impeding Realization of Target Capital Structure?” Working Paper, Washington University (2009).Google Scholar
Flannery, M., and Hankins, K.. “A Theory of Capital Structure Adjustment Speed.” Working Paper, University of Florida (2007).Google Scholar
Flannery, M. J., and Rangan, K. P.. “Partial Adjustment toward Target Capital Structures.Journal of Financial Economics, 79 (2006), 469506.Google Scholar
Frankel, R., and Lee, C. M. C.. “Accounting Valuation, Market Expectation, and Cross-Sectional Stock Returns.Journal of Accounting and Economics, 25 (1998), 283319.CrossRefGoogle Scholar
Graham, J. R., and Harvey, C. R.. “The Theory and Practice of Corporate Finance: Evidence from the Field.Journal of Financial Economics, 60 (2001), 187243.CrossRefGoogle Scholar
Hovakimian, A. “Are Observed Capital Structures Determined by Equity Market Timing?Journal of Financial and Quantitative Analysis, 41 (2006), 221243.Google Scholar
Hovakimian, A., and Li, G.. “In Search of Conclusive Evidence: How to Test for Adjustment to Target Capital Structure.” Journal of Corporate Finance, 17 (2011), 3344.Google Scholar
Hovakimian, A.; Opler, T.; and Titman, S.. “The Debt-Equity Choice.Journal of Financial and Quantitative Analysis, 36 (2001), 124.Google Scholar
Huang, R., and Ritter, J. R.. “Testing Theories of Capital Structure and Estimating the Speed of Adjustment.Journal of Financial and Quantitative Analysis, 44 (2009), 237271.Google Scholar
Jalilvand, A., and Harris, R. S.. “Corporate Behavior in Adjusting to Capital Structure and Dividend Targets: An Econometric Study.Journal of Finance, 39 (1984), 127145.Google Scholar
Korteweg, A. “The Net Benefits to Leverage.Journal of Finance, 65 (2010), 21372170.Google Scholar
Kothari, S. P., and Shanken, J.. “Book-to-Market, Dividend Yield, and Expected Market Returns: A Time-Series Analysis.Journal of Financial Economics, 44 (1997), 169203.Google Scholar
La Porta, R. “Expectations and the Cross-Section of Stock Returns.Journal of Finance, 51 (1996), 17151742.Google Scholar
Leary, M. T., and Roberts, M. R.. “Do Firms Rebalance Their Capital Structures?Journal of Finance, 60 (2005), 25752619.Google Scholar
Lee, C. M. C.; Myers, J.; and Swaminathan, B.. “What Is the Intrinsic Value of the Dow?Journal of Finance, 54 (1999), 16931741.Google Scholar
Lemmon, M. L.; Roberts, M. R.; and Zender, J. F.. “Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure.Journal of Finance, 63 (2008), 15751608.Google Scholar
Myers, S. C. “The Capital Structure Puzzle.Journal of Finance, 39 (1984), 575592.Google Scholar
Ohlson, J. A. “The Theory of Value and Earnings, and an Introduction to the Ball-Brown Analysis.Contemporary Accounting Research, 8 (1991), 119.Google Scholar
Ohlson, J. A. “Earnings, Book Values, and Dividends in Security Valuation.Contemporary Accounting Research, 11 (1995), 661687.Google Scholar
Penman, S. H., and Sougiannis, T.. “A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation.Contemporary Accounting Research, 15 (1998), 343383.CrossRefGoogle Scholar
Rhodes-Kropf, M.; Robinson, D. T.; and Viswanathan, S.. “Valuation Waves and Merger Activity: The Empirical Evidence.Journal of Financial Economics, 77 (2005), 561603.Google Scholar
Roberts, M. “The Dynamics of Capital Structure: An Empirical Analysis of a Partially Observable System.” Working Paper, Duke University (2001).Google Scholar
Shyam-Sunder, L., and Myers, S. C.. “Testing Static Tradeoff Against Pecking Order Models of Capital Structure.Journal of Financial Economics, 51 (1999), 219244.Google Scholar
Strebulaev, I. A. “Do Tests of Capital Structure Theory Mean What They Say?Journal of Finance, 62 (2007), 17471787.Google Scholar
Welch, I. “Capital Structure and Stock Returns.Journal of Political Economy, 112 (2004), 106132.Google Scholar