Introduction of market timing theory (capital structure) - Essay Example

Task Interpretation of Market Timing Theory The market timing theory analyses ways in which organisations make the decision to invest using debt or equity instruments. The theory was proposed by Baker and Wugler and is imperative in creating an understanding of the capital structure in the economy. One of its main suggestions is that managers can help in heightening the shareholders’ wealth by ensuring that they give a right timing to issues related to security. Most studies that have tested the market timing theory have found out that particular factors tend to affect security decisions for instance, interest rates and past stock prices.

Generally, it has been argued that managers often time the equity market to ensure maximum benefits (Guney and Hussain 1-2). According to Baker and Wugler (1-2) market timing is one of the major determinants used in examining an organisation’s capital structure, and how it uses its equity and debt. This means that companies do not give too much importance to whether they finance with equity or debt, but rather choose the most valued form of financing depending on the time and preference. However, critics allege that there is a need to have an inclusive market timing theory, which will help in clearly explaining why some organisations issue equity whereas others issue debt.

In that case, they allege that the market time theory is incomplete. A good example of an organisation that has benefited from market timing is the Apple Company. For instance, research shows that in 2008, the company registered significant amounts of strengths despite the recession. The organisation was successful because its management did a tremendous job of ensuring that its stocks hold up during the difficult times; therefore, it was able to make enough money while other organisations were struggling.

In 2007, Apple was named as the Business Week most successful and innovative firm. Despite the economic challenges, the company started unveiling its products such as the iPod and Itunes. The management was successful because it focused on producing simple products and ensuring they market their elegant and aesthetic designs widely; therefore, ensuring consumer satisfaction and a competitive advantage. It is alleged that the company excelled because of its prowess in technology as well as marketing and ensuring excellent timing.

Consequently, it was able to surpass most consumer electronics firms such as Dell (Hitt, Ireland, and Hoskisson 11-12). Various scholars have given limelight to the market timing theory in relation to when organisations are likely to offer equity. For instance, the theory postulates that organisations are highly likely to issue equity in case the stock prices are overrated and at the same time, repurchase equity in scenarios whereby there is a perception that the stock prices have been undervalued.

Therefore, the theory alleges that organisations often prefer equity to debt when the market value is high. According to Graham and Harvey (187-188), the amount by which a stock is overvalued or undervalued is an imperative determinant in issuing equity as most people agree that if the stock prices rise, the rate of selling equally goes up. Similarly, Huang and Ritter (3-4), agree that the market timing theory contends that organisations prefer external equity in scenarios whereby the equity costs are low, and prefer debt when the cost of equity is high.

It is argued that such kind of mispricing often occurs in cases where the investors are overly positive about the returns of a firm. In contrast, the undervaluation of the stock prices often occurs in circumstances whereby the investors possess negative believes regarding the future of an organisation. Baker and Wugler allege that companies often try to detect mispricing to be more capable of determining the market; hence, the issuance of equity. Additionally, it is assumed that companies end up issuing equity in case the investors are enthusiastic about gaining opportunities in the economy (Baker and Wugler 1-2).

Various scholars allege that market timing has a direct significance on the capital structure. In a study conducted by Baker and Wugler on a sample of the US between 1968 and 1999, it was found that market timing and market valuations have an immense impact on the capital structure. However, various researchers have different views with regard to market timing and how it affects capital structure. For instance, Mittoo and Zhang (2-3) intensively examine on the effect that market timing has on the capital structure.

In doing so, they carried out a study on Dutch as well as Canadian firms. The results showed that it is indeed factual that market timing has a direct impact on capital structure, though the impact is short-term. In that case, scholars allege that though market timing has a major influence on the capital structure, it is not persistent. Scholars allege that market timing has several advantages mostly when it comes to acquisitions and mergers. The theory suggests that managers ought to time the market, taking full advantage of the overvalued equity to benefit from an acquisition.

Additionally, it is alleged that market timers who often employ equity as a way of financing often outsmart those who are ignorant on timing the market in both long and short run. Moreover, it is argued that those organisations that time the market are more capable of exploiting opportunities fully in rewarding equity markets. This is because if managers are able to time the market appropriately, the costs of equity are likely to be lower; therefore, they would be heightening the value of a company by reducing the general costs of capital.

However, though this is true, some scholars allege that the managers would be doing so at the expense of having new shareholders; hence, the benefits end up being transferred to the old shareholders (Nanos 2-3). Generally, research shows that market timing is an imperative hypothesis in ensuring the success of an organisation. Works Cited Baker, Malcolm and Wugler, Jefferey. Market Timing and Capital Structure. The Journal of finance, 57.1(2002): 1-30 Graham, John and Harvey, Campbell. The Theory and Practice of Corporate Finance: Evidence from the Field.

Journal of Financial Economics, 60(2001):187-243 Huang, Rongbing and Ritter, Jay. Testing the Market Timing Theory of Capital Structure, 2004. Web. May 24th 2013 from< http://www3.nd.edu/~pschultz/HuangRitter.pdf> Guney, Yilmaz and Hussain, Hafezali. Capital Structure and IPO Market Timing in the UK, n.d. Web. May 24th 2013 < http://www.cass.city.ac.uk/__data/assets/pdf_file/0006/56373/2A_Guney.pdf> Hitt, Michael., Ireland, Duane and Hoskisson, Robert. Strategic Management: Competitiveness and Globalization: Concepts & Cases.

Kentucky: Cengage Learning, 2008 Mittoo, Usha and Zhang, Zhou. Market Timing, Capital Structure, and Cross Listing: Canadian Evidence, 2007. Web. May, 24th 2013 < http://69.175.2.130/~finman/Orlando/Papers/MarketTiming_CapitalStructure_CrossListing_FMA2007.pdf > Nanos, Evangelos. The Benefits of Market Timing: Evidence from Mergers and Acquisitions, n.d. Web. May 24th 2013 < http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2012-Barcelona/papers/EFMA2012_0349_fullpaper.pdf>