Capital Budgeting vs. Market Timing: An Evaluation Using Demographics

Abstract

An ongoing debate in corporate finance pits capital budgeting-equity and debt issuance are dictated by investment opportunities -against market timing-equity issuance exploits market mis-valuation. A difficulty in evaluating these theories is finding exogenous proxies for investment opportunities and for mis-valuation. In this paper, we suggest that demographic variables provide proxies for both, allowing for an evaluation of the two theories. We consider age-sensitive industries that are affected by (forecastable) shifts in cohort sizes, such as toys, beer, and nursing homes. We compare industries in which demographics induces positive demand shifts and in which it induces negative demand shifts. According to capital budgeting, industries affected by contemporaneous positive demand shifts should raise capital with IPOs and equity issuance to increase production through investment. We rely on the finding in DellaVigna and Pollet (2005) to motivate a test of market timing. Because demographic shifts 5 to 10 years ahead are not fully incorporated into asset prices, industries affected by positive demand shifts 5 to 10 years ahead are more likely to be undervalued. Hence, market timing suggests that these undervalued firms should be less likely to raise capital with IPOs and equity issuance. We find evidence to support both capital budgeting and market timing: IPOs and equity issuance respond positively to demand shifts up to 5 years ahead, and negatively to demand shifts 5 to 10 years ahead. Debt issuance and investment respond positively to demand shifts up to 5 years ahead. Capital budgeting and market timing both appear to play important roles in equity and debt issuance.