4. PERSISTENCE OF THE EFFECT OF EPS ON CAPITAL STRUCTURE
4.3 THE SEPARATION OF EPS EFFECT AND MARKING-TIMING EFFECT
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[Table 7 to be inserted here]
Table 7 shows that the coefficients on the once-lagged EPS and the weighted-average EPS have a similar sign and magnitude to those of Table 4, indicating that these variables not only influence leverage levels but also influence cumulative changes in leverage. More specifically, the coefficient on 𝐸𝑃𝑆𝑒𝑓𝑤𝑎 is significantly negative, indicating that over time the variations in EPS are a relevant and strong determinant of cumulative changes in leverage. I thus provide more evidence that EPS has persistent effects on capital structure and these effects accumulate over time. Fama-MacBeth calendar-time regressions yields no new conclusion, thus I suppress these results due to space considerations and the similarity of the findings.
4.3 The separation of EPS effect and marking-timing effect
Baker and Wurgler (2002) show that firms tend to raise capital from the equity market when share prices are perceived to be more favorable. The negative relation between EPS and capital structure can be viewed through the lens of market timing theory alone because high EPS tends to induce enthusiasm for the stock price. There is evidence that market timing relates to EPS and equity issues: Analysis of earnings forecasts and realizations around equity issues suggest that firms tend to issue equity at times when investors are rather too enthusiastic about earnings prospects (Loughran and Ritter, 1997; Rajan and Servaes, 1997; Teoh et al., 1998a, 1998b; and Denis and Sarin, 2001). I have controlled, however, for these effects by including firms’
market-to-book ratios. In addition, I perform two separate analyses to further address this issue.
First, I divide firms into five categories based on market-to-book ratio. That is, for every year of data, I sort all the firms into quintiles according to the value of their
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market-to-book ratio at the beginning of the year, and then estimate equation (1) for each group. By doing so, I rule out the explanation of the variation in market-to-book for the cross section variance of leverage changes. In other words, for each regression, I emphasize the explanatory power of the variations in EPS on firms’ leverage changes. Focusing on the book leverage results, I find that most of the coefficients on both the basic EPS and diluted EPS are significantly negative, while all of the coefficients on the market-to-book ratio are insignificant.8 These findings reveal that the effect of EPS on annual leverage changes is different from that predicted by Baker and Wurgler’s marking-timing theory. More specifically, the negative relation between EPS and leverage change is caused by the managers’ reluctance to issue new shares when EPS is low and vice versa, which is distinguishable from the negative relation between market-to-book ratio and leverage in Baker and Wurgler (2002). The results of the market leverage regression lead to a similar conclusion.
Second, I also include the external finance weighted-average market-to-book ratio suggested by Baker and Wurgler (2002) in equation (3). For a given firm-year, this is defined as
8 There are 10 subsample regressions analyzing the effect of EPS on annual change in book leverage;
five are on basic EPS and five are on diluted EPS. All coefficients on EPS are negative, but three coefficients on the EPS are insignificant among the 10 coefficients.
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significant even when controlling for 𝑀𝐵𝑒𝑓𝑤𝑎 in the same regression. On the other hand, if EPS just captures the market timing effect, then 𝐸𝑃𝑆𝑒𝑓𝑤𝑎 will no longer matter. The empirical goal is to disentangle the various determinants of capital structure by statistically identifying the significance of the different variables.
Table 8 reports the Fama-MacBeth estimates and t-statistic of the regressions considering both the persistent EPS effect and the marking-timing effect. Column (1) presents the results of multivariate regressions that use the control variables suggested by Baker and Wurgler (2002), such as once-lagged market-to-book ratio, firm size, asset tangibility, and profitability. The goal of this model is to duplicate the results of Baker and Wurgler (2002) that show the determinants of leverage. My findings, similar to that of Baker and Wurgler, indicate that the historical within-firm variation in market-to-book is important in explaining the cross section of leverage. Column (2) shows that the past variation in EPS explain a great deal of the cross section of leverage when using the control variables suggested by Baker and Wurgler (2002), which is consistent with my findings in Table 4.
[Table 8 to be inserted here]
Column (3) considers both the past variations in EPS and market values as a horse race between these two variables. The coefficients on 𝐸𝑃𝑆𝑒𝑓𝑤𝑎 and 𝑀𝐵𝑒𝑓𝑤𝑎 are both significant, which indicates that past variations in EPS and market values are two of the important determinants of cross-sectional variation in capital structures.
Column (4) includes the control variables used earlier in this paper, some of which overlap with the variables used in Baker and Wurgler. Three extra variables are R&D expenses, cash flow volatility, and industry median debt ratio. The results show that the coefficient on the weighted average EPS is not sensitive to this change in control variables. Moreover, column (4) shows that the explanatory power of the variation in
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statistical significance or the magnitude of the coefficients. I find that the managers’decisions incorporating the level of EPS have a persistent effect on firms’ leverage, and the EPS effects are separate from various effects documented in prior literature.