Question

4.1. In the period from 1977 we have largely witnessed a period of disappearing dividends. Research by Baker and Wurgler (2004) argues that the disappearing dividends are caused by firms catering to changes in investor sentiment for dividends. Briefly explain their reasoning.

4.2. Explain why managers are in a better position to exploit stock market inefficiencies than other investors.

4.3. Discuss the market timing theory with respect to managers’ decisions to issue new equity or new debt or proceed to stock repurchases.

4.4. Explain the Market timing theory in a mergers and acquisitions framework

Answer 1

4.2.

• Decision-making authority in a company lies in the hands of managers. they may pursue their own personal goals & try to maximize their own wealth.
• they may avoid taking high investment & financing risks .

4.3.  

• The market timing (or windows of opportunity) theory, states that firms prefer external equity when the cost of equity is low, and prefer debt otherwise.
• According to the market timing theory, corporate executives sometimes perceive their risky securities as misvalued by the market. Conditional on having financing needs, firms issue equity when they perceive the relative cost of equity as low, and issue debt when they perceive the relative cost of equity as high.
• How do they judge the relative cost of equity? On the one hand, they may know themselves or their industries better. On the other hand, they may follow certain psychological patterns. For example, reference points, as suggested by prospect theory, may play a role.

4.4.

• Mergers and acquisitions are frequent. Consistent with the market timing theory, firms are less likely to make stock-financed acquisitions from 1974 to 1978 when the relative cost of equity was high, and more likely to do so from 1996 to 2001 when the relative cost was low.
• The financing method of mergers and acquisitions is relevant for capital structure choices. More than 800 firms were involved in mergers and acquisitions during each of the years from 1995 to 2001.
• The balance sheet approach defines debt and equity issues using the difference between end-ofyear and beginning-of-year assets. Different accounting practices for mergers and acquisitions may lead to complications for this definition. However, it is still informative to see how the balance sheet changes when a merger or acquisition occurs. Around mergers and acquisitions, over 50 percent of firms have a net debt increase of at least five percent of beginning-of-year assets in each year. Over 40 percent of them have a net equity increase of at least five percent in each of the years 1968-69 and 1992-2001. At the other extremity, less than 18 percent of them do so each year from 1974 to 1977. Firms seem to be more likely to fund mergers and acquisitions with net equity issuance when equity market valuation is high.