The market timing hypothesis, in

corporate finance Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...

, is a theory of how firms and

corporation A corporation or body corporate is an individual or a group of people, such as an association or company, that has been authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law as ...

s decide whether to finance their investment with equity or with

debt Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...

instruments. Here, equity market timing refers to "the practice of issuing shares at high prices and repurchasing at low prices, herethe intention is to exploit temporary fluctuations in the

cost of equity In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire ca ...

relative to the cost of other forms of capital". Malcolm Baker and Jeffrey Wurgler (2002)
"Market Timing and Capital Structure"
''

The Journal of Finance ''The Journal of Finance'' is a peer-reviewed academic journal published by Wiley-Blackwell on behalf of the American Finance Association. It was established in 1946. The editor-in-chief is Antoinette Schoar. According to the ''Journal Citation R ...

''. It is one of many such corporate finance theories; it is often contrasted with the

pecking order theory In corporate finance, the pecking order theory (or pecking order model) postulates that "firms prefer to finance their investments internally, using retained earnings, before turning to external sources of financing such as debt or equity" - i.e. ...

and the trade-off theory. It is differentiated by its emphasis on the level of the market, which is seen as the first order determinant of a corporation's

capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...

: the (further) implication being that firms are generally ''indifferent'' as to whether they finance with debt or equity, choosing the form of financing, which, at that point in time, seems to be more valued by

financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial marke ...

. More generally, the Hypothesis is classified as part of the

behavioral finance Behavioral economics is the study of the psychological (e.g. cognitive, behavioral, affective, social) factors involved in the decisions of individuals or institutions, and how these decisions deviate from those implied by traditional economi ...

literature. Here, it does not attempt to explain why there would be any asset mispricing, or why firms would be better able than the than "the market" in telling that there is mispricing (see

Efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis ...

). Rather, it simply assumes that mispricing exists, and describes the behavior of firms under various market and corporate outcomes. The

empirical evidence Empirical evidence is evidence obtained through sense experience or experimental procedure. It is of central importance to the sciences and plays a role in various other fields, like epistemology and law. There is no general agreement on how the ...

for the hypothesis is mixed. On the one hand, current capital structure appears strongly related to historical market values, suggesting that "capital structure is the cumulative outcome of past attempts to time the equity market". On the other, studies show that the effect of market timing disappears after as little as two years. In particular, "the impact of market timing on leverage completely vanishes", with debt issued following equity financing during earlier hot equity periods. Further, the (standard version of) the hypothesis is said to be somewhat incomplete as relates to theory. Beyond empirical study, as alluded to, a model is needed to explain why at the same moment in time, some firms issue debt while other firms issue equity.

References

{{reflist Corporate finance Debt Finance theories

See also

References