152 M. Baker et al.
In words, the first condition is about investment policy. The marginal value created
from investment is weighed against the standard cost of capital, normalized to be one
here, net of the impact that this incremental investment has on mispricing, and hence its
effect through mispricing on catering and market timing gains. The second condition is
about financing. The marginal value lost from shifting the firm’s current capital structure
toward equity is weighed against the direct market timing gains and the impact that this
incremental equity issuance has on mispricing, and hence its effect on catering and
market timing gains. This is a lot to swallow at once, so we consider some special
cases.
Investment policy. Investment and financing are separable if bothδKandfeare equal
to zero. Then the investment decision reduces to the familiar perfect markets condi-
tion offKequal to unity. Real consequences of mispricing for investment thus arise
in two ways. InStein (1996)andBaker, Stein, and Wurgler (2003),feis not equal to
zero. Thereisan optimal capital structure, or at least an upper bound on debt capacity.
The benefits of issuing or repurchasing equity in response to mispricing are balanced
against the reduction in fundamental value that arises from too much (or possibly too
little) leverage. InPolk and Sapienza (2004)andGilchrist, Himmelberg, and Huberman
(2005), there is no optimal capital structure, butδKis not equal to zero: mispricing is
itself a function of investment. Polk and Sapienza focus on catering effects and do not
consider financing (eequal to zero in this setup), while Gilchrist et al. model the market
timing decisions of managers with long horizons (λequal to one).
Financial policy. The demand curve for a firm’s equity slopes down under the natural
assumption thatδeis negative, e.g., issuing shares partly corrects mispricing.^4 When
investment and financing are separable, managers act like monopolists. This is easiest
to see when managers have long horizons, and they sell down the demand curve until
marginal revenueδis equal to marginal cost –eδe. Note that price remains above fun-
damental value even after the issue: “corporate arbitrage” moves the market toward, but
not all the way to, market efficiency.^5 Managers sell less equity when they care about
short-run stock price (λless than one, here). For example, inLjungqvist, Nanda, and
Singh (2006), managers expect to sell their own shares soon after the IPO and so is-
sue less as a result. Managers also sell less equity when there are costs of suboptimal
leverage.
Other corporate decisions. Managers do more than simply invest and issue equity,
and this framework can be expanded to accommodate other decisions. Consider divi-
dend policy. Increasing or initiating a dividend may simultaneously affect both funda-
mental value, through taxes, and the degree of mispricing, if investors categorize stocks
(^4) Gilchrist, Himmelberg, and Huberman (2005)model this explicitly with heterogeneous investor beliefs
and short-sales constraints.
(^5) Total market timing gains may be even higher in a dynamic model where managers can sell in small
increments down the demand curve.