Understanding the Role of the Market-to-Book Ratio in Corporate Financing Decisions

Abstract

It is well documented that the market-to-book ratio is a key capital structure determinant. However, because the related empirical evidence can be explained by competing capital structure theories, a large controversy remains regarding the economic interpretation of the variable. This study designs tests that can separate the predictions of the competing theories. While we find that firms with higher market-to-book ratios are persistently more likely to issue equity, there is no evidence suggesting that the equity issuance is driven by target leverage ratio adjustment. The direct implication is that, because the target ratio consideration appears to be of secondary concern, past market-to-book ratios, through persistent financing policies, can explain current leverage ratios even after fully controlling for growth opportunities. This conclusion holds firm with extensive robustness checks, alternative variable measures, and different sample choices.

Keywords: Capital structure, tradeoff theory, pecking order theory, market timing hypothesis, market-to-book ratio, bankruptcy risk

JEL Classification: G32