Market Timing and Capital Structure

Traditional capital-structure theories assume managers pick a debt-to-equity mix based on taxes, bankruptcy costs, or a target ratio, and then adjust toward it over time. Baker and Wurgler's market timing theory offers a different story: managers issue whichever security — debt or equity — feels cheapest to sell at the moment, and leverage is simply whatever is left over from a history of those opportunistic choices.

What the evidence shows

Baker and Wurgler found that a firm's current leverage is well predicted by a weighted average of its past market-to-book ratios at each time it raised capital — firms that happened to issue a lot of equity during periods of high valuation end up with persistently lower leverage for years afterward, not because they deliberately chose to stay low-debt, but because they never later readjusted back toward a fixed target.

Worked example

A firm's stock trades at 3x book value during a hot market and it issues $500 million of new equity to fund growth, cutting its debt ratio sharply. Two years later its stock has fallen to 1.2x book value; under a target-leverage story it should now issue debt to rebalance back up, but the market timing theory instead expects it to avoid new equity issuance simply because equity now looks "expensive" to give up at a lower price — and empirically, leverage ratios that result from timing decisions like this one tend to persist for many years rather than reverting toward some fixed target debt ratio.