Essay 1: Financing the Deficit: Debt Capacity, Information Asymmetry, and the Debt-Equity Choice. If Pecking Order behavior of financing choice is mitigated by debt capacity concerns, then Tradeoff and Pecking Order theories are difficult to distinguish empirically. In this paper, we extend the Myers and Majluf (1984) model to derive new testable implications of the interaction between adverse selection costs and debt capacity constraints. Our model predicts that the probability of debt issuance will be a non-monotonic function of the size of the financing deficit. The probability of debt issuance will initially increase in the size of the deficit as adverse selection costs of issuing equity outweigh the costs due to loss of debt capacity, then decrease as costs due to loss of debt capa...[ Read more ]

Essay 1: Financing the Deficit: Debt Capacity, Information Asymmetry, and the Debt-Equity Choice. If Pecking Order behavior of financing choice is mitigated by debt capacity concerns, then Tradeoff and Pecking Order theories are difficult to distinguish empirically. In this paper, we extend the Myers and Majluf (1984) model to derive new testable implications of the interaction between adverse selection costs and debt capacity constraints. Our model predicts that the probability of debt issuance will be a non-monotonic function of the size of the financing deficit. The probability of debt issuance will initially increase in the size of the deficit as adverse selection costs of issuing equity outweigh the costs due to loss of debt capacity, then decrease as costs due to loss of debt capacity become more important, and finally increase again as the deficit becomes very large. Our empirical tests on a sample of firms from Compustat from 1971-1998 classified into five size groups demonstrate that, even after allowing for the possible endogeneity of the financing deficit, the predicted non-monotonicity prevails for all size groups of firms. Even for those firms in the smallest size group for which debt capacity is not a dominant concern, the initial range over which the relationship between the deficit size and the probability of debt issue is significantly positive includes as much as 67% of all issues. Consistent with the predictions of the model, the intermediate range between the two turning points (over which the probability of debt issue decreases in the size of the deficit and debt capacity concerns dominate) is larger for smaller and younger firms. It is also larger for firms with lower past profitability, and firms with higher growth opportunities. We also find that the probability of debt issue is lower (higher) for firms that are above (below) an estimated target debt ratio, and higher for firms with higher past profitability, lower market-to-book, and poor recent stock price performance. Aside from demonstrating the relevance of both adverse selection costs and debt capacity constraints for firms' financing decisions, our results also show that firms exhibit target-reverting behavior and time the market.

Essay2: Analyst Following and Capital Structure Decisions. We provide evidence that firms that have greater analyst following depend less on favorable market conditions for their equity issuance decisions. First, debt ratios of firms with more analyst following are less affected by Baker and Wurgler's (2002) external-finance weighted market-to-book ratio than those with fewer analysts. Second, these firms are less likely to issue debt, or large amounts of equity at once, relative to more frequent smaller issues of equity. Third, although all firms issue larger amounts of equity after favorable stock returns, this tendency is less pronounced for firms with higher analyst coverage. While greater analyst following also reduces firms' incentives to time debt issues, the effect is less important than for equity issues. We also find that firms with more analyst following have lower target debt ratios. Moreover, firms with more analysts show both lower cash flow-sensitivity and Q-sensitivity of investment. These results are consistent with the effect of information asymmetry on capital structure predicted by the different theories.

Essay 3: Inefficient Divestures: A theoretical perspective. Existing literature has focused almost exclusively on the reluctance of managers to divest poorly performing assets, and the value gains that result when divestitures occur. In this paper, we argue that managers may also have a bias towards divesting "too much". A manager's divestiture decisions affect firm value because divestitures signal the manger's ability and willingness to make right decisions. Due to labor market concerns, less capable managers have incentives to jam the market inference about their ability by randomly divesting the projects without any reliable information. We establish that in equilibrium, less capable managers are trapped to behave inefficiently and there would be too much divestiture when certain conditions are satisfied. Our analysis leads to several empirical predictions that are consistent with evidence documented in previous studies.