Market Timing and Capital Structure for Baker and Wurgler

2. Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered beta CAPM equation

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (Eds.). (2011). Essentials of corporate finance (7th ed., Rev.). New York, NY: McGraw-Hill Irwin.

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

Book ratios are calculated by looking at historical costs or accounting values of the firm whilst market ratios are determined in stock markets through capitalization processes. From the above figures, it is apparent that market ratios are lower than book ratios. This indicates that either equities were overvalued or debts were undervalued to result in the higher debt-to-equity ratios. The two companies therefore have to rectify their valuation methods that concern liabilities and equities. When their valuations tend to match those of market valuations, they may correspond to what the company can actually be valued at when sold today. It is evident that BHP Billiton has a higher leverage ratio, indicating that the company uses a higher proportion

Apple is still the world's largest company financially according to Google’s recent earnings report. Apple has a $521.3 billion market funding, as of Feb. 5, 2016. Now, I will like to analyze the importance of Apple debt ratios. Apple increases its capital return program in 2015 with the hopes of returning $200 billion to its investors by March 2017, from that Apple’s debt offerings is now over $55 billion as of September 2015. Appropriate measurements in finding Apple's debt include the debt-to-equity, debt, cash flow-to-debt and capitalization ratios. The debt ratio indicates a company's degree of advantage, which is calculated by dividing its total debt by its total assets during an accounting period. A high debt to equity ratio

Baker, M. & Wurgler, J. 2002, ‘Market Timing and Capital Structure,’ Journal of Finance, vol. 57, pp 1-32

Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that

As much as market cap measures to what’s related to the company’s equity value, a firm’s decision based on its capital structure estimates more significantly to how the value of that company is allocated not only for the return on equity but accounting for debt as well. Most economists would refer to capital structure as the mix of a company’s long-term debt, the current portion of it, and of common and preferred stock. Furthermore, large tech-companies today have been taking advantage of capital structure optimizations as it is placed shoulder to shoulder to increasing return on equity thus lowering weighted average costs of capital for long-term investment. In other words, it is how a corporate manager should base his/her decisions on financing the company’s assets and operations through various growth prospects and forecast estimates. We will begin to further evaluate the composition of Google’s capital structure by focusing on the company’s key statistics and research data from the selected top online providers of financial statements, including Google!

Rational investors are likely to infer a higher firm value from a higher debt level. Thus, these investors are likely to bid up a firm’s stock price after the firm has issued debt in order to buy back equity. We say that investors view debt as a signal of firm value. Moreover, corporations can

If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.

Capital structure is defined as the mix of the long-term sources of funds that a firm use. It is composed of equity, debt securities and affect long-term financing of the entity. It is made up by shareholder’s funds, long-term debt and preference share capital. The capital structure mostly focus on the proportions of debt and equity displayed in the company financial statements, especially in the balance sheet (Myers, 2001). The value of a firm can be calculated by the sum of the value of its firm’s debt and equity.

Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).

Financial management encompasses a broad array of different methodologies, key performance metrics, and news and events, amongst many other segments. From the smallest of public companies, to global giants, data is continuously compiled and analyzed to gauge performance and predict future trend. Of course, these studies can never be completely accurate, as market performance is unpredictable and sometimes quite volatile. It’s because of the unknown that the constant fluctuation of individual stocks and overall markets is present. These fluctuations are tied to many different factors, including the key data that companies release. It’s from this data, such as annual reports, that analysts can gauge the performance of the company and investors can decide the fate of the share price from the buying and selling activities they perform. Other events also play a major role in the markets and in the overall examination of financial management, such as initial public offerings and secondary offerings, and these instances provide fuel to an already complicated system of gauging and predicting the market. Truly, the factors used to analyze a market are limitless. Even extraneous variable, such as bond yields, are used to predict future market movement. In the below detail, some of the general facets of financial management and market analysis will be examined. Our discussion of the issues of financial management for the scope of this project have been directed at the major

This study will further lead to the dynamics of KSE listed firms. Investor trends towards highly leveraged firms and determination whether the optimum capital structure effects the decision of investor resulting change in the balance sheet of a company.

If external financing is required, the “safest” securities, namely debt, are issued first. Although investors fear mispricing of both debt and equity, the fear is much greater for equity. Corporate debt still relatively little risk compared to equity because, if financial distress is avoided, investors receive a fixed return.. Thus, the pecking order theory implies that, if outside financing required, debt should be issued before equity. Only when the firm’s debt capacity is reached should the firm consider equity.