This study aims to investigate the validity of the market timing theory of capital structure for a developing country, namely Malaysia, and to examine and reconcile the contradictory findings of past research about the coexistence of both timing behavior and adjustment towards the target behavior. Market timing theory differs from trade-off theory. Market timing theory presumes that the market valuation of the firm affects the leverage ratio through the mispricing component of the market valuation and that the effect of timing on leverage ratio is persistent. In trade-off theory, the effect of market valuation on leverage comes through the growth options component of market value and the effect is transitory because of the adjustment behavior. Using unbalanced panel data from 1027 Malaysian firms for the period between 1991 and 2009 period, this study utilizes both static and dynamic frameworks to provide new insight into the capital structure choice of Malaysian firms. The market timing theory is found to be a valid interpretation for the role of market valuation in determining the capital structure choice. Specifically, the current market valuation of the firm is found to be the only reliable factor that positively affects the decision to issue new common stock. The historical market timing activities are found to negatively affect the leverage ratio and this effect is found to be more important than the effect of the current market valuation on leverage. While current market valuation may capture timing opportunities of mispricing periods, as well as growth options, the historical timing variable is likely to capture the effect of timing activities free from growth options. The negative relationship with historical timing implies that mispricing plays a significant role in the capital structure choice. On the other hand, the investigation of the persistence of leverage ratio reveals that the firm is gradually closing the gap with the target at a slow speed of adjustment, which indicates that trade-off factors are at work. However, the slow speed of adjustment does not provide sufficient evidence to make targeting behavior a priority for the firm. This study proposes that the two motives of timing and targeting may co-exist, but the preference of one motive over the other is conditional and depends upon the direction of the deviation from the target. The results support that the speed of adjustment is higher and the timing role is lower for overleveraged firms compared with underleveraged firms. These results indicate that overleveraged firms find less flexibility to time the market as more pressure is exerted on them to return to the target, irrespective of the timing opportunities, because of the higher costs of deviation from the target leverage. Underleveraged firms place a lower priority upon rebalancing towards the target compared with overleveraged firms because the costs of being underleveraged are lower. Hence, underleveraged firms have more flexibility to time the market.

Title

The National University of Malaysia

Publisher

UKM

Publisher Country

Malaysia

Publication Type

Both (Printed and Online)

Volume

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Year

2012

Pages

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