At its most basic level, corporate finance concerns the choice of new investments and decisions about how to finance those investments. Each of these decisions has been studied extensively, but usually in isolation from the other. However, it may be inappropriate to study financing and investment decisions separately. New investments must be financed, and the financing decision may it self affect firm value by changing investors expectations. The connections between capital structure and investment decisions should be most apparent when a firm undertakes a large investment (Mayer and Sussman [2004]).
We have assembled a sample of such firms and study their financing decisions and their long-run stock-market performance. We screen all Compustat firms to identify those that made "major" investments during the period 1989-1999. We separately identify major internal or "built" investments (Compustat item #128, "capital expenditures") and investments "acquired" from outside the firm (Compustat item #129, "acquisitions"). We then use Compustat flow-of funds data to infer how these major investments were financed. We use this sample to study two questions. First, what determines the combination of equity and debt securities issued to finance large investments? Second, how do various combinations of investment types and financing sources affect a firm's long-run equity performance?
Our capital-structure results can be summarized as follows. We find that major investments are mostly externally financed, with new debt providing at least half the required funds in the year of the investment. Only about 15 - 20% of the typical investment is financed by the sale of equity, with internal funds supplying most of the remainder. In the event year, firm financing choices reflect some pecking order and market timing effects, but firms systematically revise their initial financing decisions in subsequent years. Retained earnings and new equity issues pay down debt.
Ultimately, these financing decisions are consistent with the trade-off hypothesis about capital structure: a firm's external securities issuance reflects its position vis-à-vis a firm-specific, target debt ratio computed from the usual combination of firm features. We also find that financing proportions vary with firm size: smaller firms rely more on external equity funds, which seems inconsistent with the pecking order theory of capital structure (Frank and Goyal [2003], Fama and French [2003]). Finally, the data reflect a tendency for firms with higher Tobin's Q to fund themselves by issuing new securities.
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Major Investments, Firm Financing Decisions, and Long-run Performance
