A central question in corporate finance literature relates to the choice between debt and equity. The debate on capital structure choice has been fueled by the publication of the article of Modigliani and Miller (1958). These pioneers of finance beg the question of the pertinence of capital structure. They demonstrated that in efficient, perfect, and integrated capital market, firms draws no gains from opportunistically switching between debt and equity.
Therefore, firms can not reduce the overall capital cost by adopting one financial structure instead of another. Subsequently, the static trade-off theory suggests that there is an optimal capital structure determined by the tax structure, costs of financial distress, and agency problems. A deviation from this target level of debt pushes firms to adopt an adjustment process toward this optimum.
The second major theory of capital structure is the pecking order theory described by Myers and Majluf (1984). They discuss the impact of asymmetric information in case investors are less informed about the value of the firm than insiders. In the Myers and Majluf framework, investors interpret equity issues as bad news because the firm is expected overvalued. As a result, firm securities would be underpriced. To overcome this underpricing problem, firm should adopt a financing hierarchy starting by internal funds, then debt, and equity as a last resort.
Recently, the market timing theory has challenged both static trade-off and pecking order theories by assuming that observed capital structure is the outcome of past abilities to time equity issues. As defined by Baker and Wurgler (2002), equity market timing refers to the practice of issuing shares at high prices and repurchasing at low prices. The intention is to exploit the temporary fluctuations in the cost equity relative to other forms of capital. Under normal market conditions, firms follow the standard pecking order with internal financing preferred to external financing, and equity issued only as a last resort. When external equity is less expensive than debt, however, firms prefer external equity if they seek external financing.
Identifying market timers as those firms that have a history of raising capital at high market-to-book ratios, Baker and Wurgler (2002) find persistent timing effects on leverage that extend beyond ten years. They conclude that that capital structure is determined by past attempts to time the market. Survey evidence in Graham and Harvey (2001) reveals market timing to be a primary concern of corporate financial officers. However, the persistence of timing behavior on capital structure is not obvious. Baker and Wurgler (2002), Huang and Ritter (2005) emphasize the persistence of market timing effects. Alti (2006), and Leary and Roberts (2004) find that the impact of equity issuance on capital structure completely disappears within two to four years.
In this paper we attempt to investigate the impact of market conditions on the equity issuance and the persistence of the equity market timing on capital structures of Tunisian and French firms. This study makes two main contributions to the literature. Our first contribution is to connect net equity issues to a variable that reflects debt market conditions. Previous studies on the market timing behavior ignored the cost of debt. They included only the cost of equity as an explanatory variable.
However, considering only equity cost may lead to wrong interpretations. We could interpret a positive relationship between favorable conditions of the equity market as genuine market timing, while actually managers are just trying to avoid unfavorable conditions in the debt market. A no significant relationship between for example market valuations or prices increase and equity proceeds could be interpreted as an evidence that managers are non-timers, while in fact firms are just taking advantage from more favorable conditions in the debt market. Thus, including the cost of debt when we investigate the equity market timing might be very worthwhile and fruitful.
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