Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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456 Answers to Chapter Discussion Questions

CHAPTER 10 TRADE-OFF, PECKING ORDER,

SIGNALING, AND MARKET TIMING MODELS

1. Long-term underperformance of firms issuing equity involves two aspects. One

regards the operating performance of these firms. Operating performance of

firms issuing equity decreases relative to operating performance of non-issuing

firms. The second aspect involves the controversial topic of stock underper-

formance. Some evidence shows that stock returns of companies issuing new

shares underperform in the long run compared to the returns of non-issuing

firms (Ritter and Welch 2002). However, financial leverage increases a firm’s

financial risk, its beta, and the financial risk of investments in equity. Compa-

nies issuing shares have lower leverage compared to non-issuing firms. Eckbo,

Masulis, and Norli (2007) and Carter, Dark, and Sapp (2009) argue that no such

puzzle exists regarding the long-term underperformance of newly issued stocks

because risk changes after capital structure changes.

2. “Target reversion” or “mean reversion” is the continuous process of adjusting

capital structure toward the target ratio (Shyam-Sunder and Myers 1999; Frank

and Goyal 2003). Trade-off theory provides an explanation for mean reversion.

Namely, debt changes should be dictated by the difference between the current

level of debt and the level predicted by Equation 10.2. The difficulty of conduct-

ing econometric ...