On the Relation Between the Market-to-Book Ratio, Growth Opportunity, and Leverage Ratio Long Chen and Xinlei Zhao Dis

1. On the Relation Between the Market-to-Book Ratio, Growth Opportunity, and Leverage RatioLong ChenandXinlei ZhaoDiscussion byMichael R. RobertsThe Wharton School

2. Paper Goals: Understand the theoretical relation between growth opportunities and capital structure Understand the empirical relation between growth opportunities and capital structure Empirically examine existing theories of capital structure (e.g., market timing, pecking order, and tradeoff) Approach: Reexamine the theoretical arguments put forth by Myers (1977) Look more closely at empirical association between market-to-book and leverage Revisit recent empirical debate concerning capital structure theory

3. Messages of the Paper Empirical implication of Myers (1977): Theory does not predict inverse association between growth opportunities and leverage Relation between market-to-book and leverage: For majority of firms, observed positive relation between market-to-book and leverage (i.e., leverage is a nonlinear function of market-to-book) Evidence regarding capital structure: Evidence primarily consistent with Baker and Wurgler�s (2002) market timing and elements of pecking order and tradeoff, as well

4. Comments What I enjoyed about the paper: Ambitious New and interesting result concerning (empirical) association between market-to-book and leverage Areas for improvement and clarification Interpretation of existing empirical literature Interpretation of results & empirical issues Organization and focus of the paper

5. Interpretation of Existing Empirical Literature Much of the paper is spent convincing reader that firms issue equity when valuations are high�but we know this from Taggart (1977), Marsh (1982), Asquith and Mullins (1986)... Baker & Wurgler (2002) take this as given and then argue that it�s impact on capital structure dominates all other (e.g., tradeoff) considerations. Recent debate is not whether firms issue equity when M/B is high but whether �capital structure is the cumulative outcome of attempts to time the equity market.� -�Korajczyk, Lucas, and McDonald (1991), Jung, Kim, and Stulz (1996), Hovakimian, Opler, and Titman (2001). -B&W motivate their paper, indeed list these references in footnote 1, with this empirical observations. They then ask, �what impact does this timing have on capital structures. They argue that it is 1) large and 2) highly persistent dominating all other considerations.-�Korajczyk, Lucas, and McDonald (1991), Jung, Kim, and Stulz (1996), Hovakimian, Opler, and Titman (2001). -B&W motivate their paper, indeed list these references in footnote 1, with this empirical observations. They then ask, �what impact does this timing have on capital structures. They argue that it is 1) large and 2) highly persistent dominating all other considerations.

6. Interpretation of Results & Empirical Issues Authors find: Equity issuers are more likely to subsequently issue equity again compared to non-issuers Equity issues have a persistent effect on capital structure Much of the rebalancing is achieved through retained earnings Conclude: �Market timing plays an important role�and has a lasting effect on firm leverage ratios.� But�

7. Leverage Dynamics with Adjustment Costs: Proportional Costs Consider this dynamic tradeoff view of the world, where market frictions (e.g., transaction costs) are relevant, consistent with papers by Fischer, Heinkel, and Zechner (1989), Mauer and Triantis (1994), Goldstein, Ju, and Leland (2001), Strebulaev (2004). Proportional cost -every dollar of issuance/retirement is penalized (at equal rate) ? issue/retire min amount to min adj costs -Results in tiny adjustments, highly clustered in time (Constantinides (1979) portfolio selection)Consider this dynamic tradeoff view of the world, where market frictions (e.g., transaction costs) are relevant, consistent with papers by Fischer, Heinkel, and Zechner (1989), Mauer and Triantis (1994), Goldstein, Ju, and Leland (2001), Strebulaev (2004). Proportional cost -every dollar of issuance/retirement is penalized (at equal rate) ? issue/retire min amount to min adj costs -Results in tiny adjustments, highly clustered in time (Constantinides (1979) portfolio selection)

8. Conclusions Do Not Follow from Results The tests of capital structure theories often have low (no) power (e.g., Strebulaev (2004), Hennessy and Whited (2004), Leary and Roberts (2004a)) The results can be interpreted as consistent with several explanations (e.g., mispricing, pecking order, trade-off, etc�) but then what have we learned? *Multinomial logit does not work here (inconsistent estimates) because i.i.a. is probably violated (Gomes and Phillips (2004), Leary and Roberts (2004b)) Can try multinomial probit with explicit dependence structure (estimate via MCMC, simulated annealing, SMM, etc.) or nested logit with proper restrictions.

9. Suggestions Organization of the Paper Doing too many things and the analysis suffers Reinterpreting Myers Re-examining the empirical relation between market-to-book and leverage Examining the meaning of market-to-book Testing theories of capital structure Focus on one theme. E.g., Myers (1977) theoretical and empirical implications. Clarify the relation between growth and capital structure (assuming that this is needed.) -Currently the paper, I think, is trying to do too many things and as a result the analysis suffers on each front. Additionally, it makes it difficult to read the paper because there is only a weak thread linking all of these related but separate concepts. Attempting to reinterpret Myers (1977), reexamine the empirical relation between leverage and market-to-book, r -By focusing on one question or one theme, you can really attack the issue completely from all angles hopefully allowing you to present convincing evidence supporting (or refuting) a specific point.-Currently the paper, I think, is trying to do too many things and as a result the analysis suffers on each front. Additionally, it makes it difficult to read the paper because there is only a weak thread linking all of these related but separate concepts. Attempting to reinterpret Myers (1977), reexamine the empirical relation between leverage and market-to-book, r -By focusing on one question or one theme, you can really attack the issue completely from all angles hopefully allowing you to present convincing evidence supporting (or refuting) a specific point.

10. Concluding Remarks Greater care needs to be exercised in interpreting the existing empirical literature The paper needs to focus and sharpen empirics to avoid power problems and statistical issues. There is an interesting empirical result concerning the association between market-to-book and leverage We know elements of different theories are present in financial policy. The question is what is most important and when.