Capital Budgeting vs. Market Timing: An Evaluation Using Demographics

An ongoing debate in corporate finance pits capital budgeting–equity issuance is dictatedby investment opportunities –against market timing–equity issuance exploits marketmis-valuation. A difficulty in evaluating these theories is finding exogenous proxiesfor investment opportunities and for mis-valuation. In this paper, we suggest that demographicvariables provide proxies for both, allowing for an evaluation of the two theories.We consider age-sensitive industries that are affected by (forecastable) shifts in cohort sizes,such as toys, beer, and nursing homes. We compare industries in which demographics inducespositive demand shifts and in which it induces negative demand shifts. According tocapital budgeting, industries affected by contemporaneous positive demand shifts shouldraise capital with IPOs and equity issuance to increase production through investment. Werely on the finding in DellaVigna and Pollet (2005) to motivate a test of market timing.Because demographic shifts 5 to 10 years ahead are not fully incorporated into asset prices,industries affected by positive demand shifts 5 to 10 years ahead are more likely to beundervalued. Hence, market timing suggests that these undervalued firms should be lesslikely to raise capital with IPOs and equity issuance. We find evidence to support both capitalbudgeting and market timing: IPOs and equity issuance respond positively to demandshifts up to 5 years ahead, and negatively to demand shifts 5 to 10 years ahead. Capitalbudgeting and market timing both appear to play important roles in equity issuance.