Disentangling the Effects of Stock Returns,Equity Market Timing and Firm Specific Characteristics on Capital Structure

Abstract

Recent prior research has had contradicting findings as to whether it is equity market timing or stock returns which is the major determinant of capital structure. In this paper we make attempts to disentangle the effects of equity market timing practice from that of stock returns on UK firms’ capital structures in order to reach a verdict as to which one is the major determinant of capital structure. We document that although equity market timing practice has statistically significant effects on gearing, stock returns are the most important capital structure determinant. Further robustness tests show that although the effect of equity market timing and firm-specific characteristics such as profitability, growth opportunities, size, and non-debt tax shields, is persistent and statistically significant, compared to stock returns effect, their economic role is negligible. Stock returns drive gearing mechanistically for a long time, even for more than 10 years. The results also show that managers do not strive to adjust their capital structure towards some optimal debt ratio when their debt-carrying capacity increases. The findings imply that there is no optimal capital structure.