Three Essays on Empirical Finance

Abstract

This dissertation consists of three essays on empirical finance. In the first essay, I examine whether firms strategically substitute equity for debt to exploit market mispricing. I argue that previous studies reach conflicting conclusions about equity market timing because they neglect a confounding investment-in-growth-options effect. Using alternative testing procedures, I find evidence in support of the market timing hypothesis. Specifically, I find firms issue more equity relative to debt when analysts are more overoptimistic about their growth prospects and earn lower event returns at subsequent earnings announcements. After controlling for the confounding investment-in-growth-options effect, I find that these firms earn lower year-ahead stock returns than those issuing more debt relative to equity.

In the second essay, I examine firm-specific heterogeneity in firms’ leverage decisions. I find that leverage models are characterized with heterogeneous slopes. I show that, by neglecting slope heterogeneity, the standard fixed effect estimation of leverage models can produce pseudo fixed effects. The presence of such mechanical effects should not be interpreted as evidence of time invariant leverage targets or evidence that previously identified capital structure determinants are unimportant (Lemmon, Roberts and Zender (2008)). With proper controls for slope heterogeneity, previously identified capital structure determinants can explain a much larger proportion of the variation in leverage. The evidence in this paper suggests that it is more appropriate to view firms as having heterogeneous sensitivities toward the changes in capital structure determinants (i.e., heterogeneous slopes in leverage models) than to view firms as being associated with firm-specific, time invariant leverage levels (i.e., heterogeneous intercepts in leverage models).

In the third essay, I provide evidence for the use of size- and book-to-market (BM) based relative performance evaluation in deciding executive compensation. Specifically, I find a negative relation between CEOs’ total compensation and the performances of firms’ size and BM peer groups. Further analysis shows that my findings are more consistent with the relative performance evaluation model than with the managerial entrenchment hypothesis.