Abstract
In this paper, I build a dynamic trade-off model of financing with difference in beliefs between the manager and investors. In the model, investors update more readily on earnings announcements than the manager does. The model offers a parsimonious treatment of endogenous financing, payout, and cash policies. The model generates a broad set of well-documented empirical facts that are difficult to explain using standard theories. In particular, the model predicts: 1) high stock returns predicting equity issuance, 2) the low debt ratios of firms in cross-section, 3) the substantial presence of firms with no debt or negative net debt and the fact that zero-debt firms are more profitable, pay larger dividends, and keep higher cash balances than other firms, and 4) the negative relationship between profitability and both book and market leverage ratios. If investors overextrapolate trends in earnings growth, the model also predicts the negative/positive long-run abnormal returns following stock issuances/repurchases.
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