Does Market Timing or Enhanced Pecking Order Determine Capital Structure?

Abstract

We explore the idea that a firm's financing behavior depends crucially on how its ownership structure affects the cost differential between internal and external equity. If ownership is dispersed, the cost differential is relatively small. By issuing public offers when market-to-book values are high, incumbent shareholders benefit if equity is mispriced. The market timing theory predicts that firms' lower leverage is mainly the cumulative result of successful market timings. But if ownership (capital) is separated from control (votes), agency costs due to widespread use of dual-class shares drive a wedge between the costs of internal and external equity as new external shareholders demand compensation. This generates an enhanced pecking order: new equity (rights issues or private placements) is issued only when internal equity and debt are insufficient while public offers are not used since compensating transfers from incumbents to external shareholders needed. The behavior of US IPO firms is consistent with the market timing theory (Baker and Wurgler (2002)) while the enhanced pecking order theory best explains how Swedish IPO firms behave and why market timing is not important. Our results challenge the generality of the market timing theory.