Market Timing and Capital Structure

We trace capital structure to past market valuations. Unlevered firms tend to be those that raised funds when their valuations were high, as measured by the market-to-book ratio. Levered firms tend to be those that raised funds when their valuations were low. The results are difficult to reconcile with the tradeoff theory because temporary changes in market-to-book lead to permanent changes in capital structure. The results are also difficult to reconcile with the pecking order because temporary increases in market-to-book lead to permanent increases in cash balances. The results are consistent with the theory that capital structure is the cumulative outcome of a series of market-timing-motivated financing decisions