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The success of the market-timing framework in predicting patterns of eq-
uity issuance offers the hope that it might also be the basis of a successful
theory of capital structure. After all, a firm’s capital structure simply repre-
sents its cumulative financing decisions over time. Consider, for example,
two firms which are similar in terms of characteristics like firm size, prof-
itability, fraction of tangible assets, and current B/M ratio, which have tra-
ditionally been thought to affect capital structure. Suppose, however, that
in the past, the B/M ratio of firm A has reached much higher levels than
that of firm B. Since, under the market timing theory, managers of firm A
may have issued more shares at that time to take advantage of possible
overvaluation, firm A may have more equity in its capital structure today.
In an intriguing recent paper, Baker and Wurgler (2002a) confirm this
prediction. They show that all else equal, a firm’s weighted-average histori-
cal B/M ratio, where more weight is placed on years in which the firm made
an issuance of some kind, whether debt or equity, is a good cross-sectional
predictor of the fraction of equity in the firm’s capital structure today.
There is some evidence, then, that irrational investor sentiment affects fi-
nancing decisions. We now turn to the more critical question of whether
this sentiment affects actual investment decisions. Once again, we consider
the benchmark case in Stein’s (1996) model, in which the manager is both
rational and interested in maximizing the firm’s true value.
Suppose that a firm’s stock price is too high. As discussed above, the
manager should issue more equity at this point. More subtly, though, Stein
shows that he should notchannel the fresh capital into any actual new in-
vestment, but instead keep it in cash or in another fairly priced capital
market security. While investors’ exuberance means that, in theirview, the
firm has many positive net present value (NPV) projects it could under-
take, the rational manager knows that these projects are not, in fact, posi-
tive NPV and that in the interest of true firm value, they should be
avoided. Conversely, if the manager thinks that his firm’s stock price is ir-
rationally low, he should repurchase shares at the advantageously low
price but not scale back actual investment. In short, irrational investors
may affect the timing of security issuance, but they should not affect the
firm’s investment plans.
Once we move beyond this simple benchmark case, though, there emerge
several channels through which sentiment might affect investment after all.
First, the above argument properly applies only to non-equity dependent
firms; in other words, to firms which because of their ample internal funds
and borrowing capacity do not need the equity markets to finance their
marginal investments.
For equity-dependent firms, however, investor sentiment and, in particu-
lar, excessive investor pessimism, may distort investment: when investors
are excessively pessimistic, such firms may have to forgo attractive invest-
ment opportunities because it is too costly to finance them with undervalued


A SURVEY OF BEHAVIORAL FINANCE 57
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