Conglomerate Structure and Capital Market Timing

Conglomerate Structure and Capital
Market Timing
Xin Chang, Gilles Hilary, Chia Mei Shih, and Lewis H.K. Tam
We examine the effects of keiretsu structure on capital market-timing. Keiretsu groups offer
a hybrid structure between fully integrated conglomerates and stand-alone firms. We find that
past market conditions affect the capital structure of keiretsu firms more than they affect the
capital structure of unaffiliated firms. The decision to issue equity is more correlated with market
conditions for keiretsu members than it is for unaffiliated firms. The stock returns of keiretsu firms
following the issuance of equity decrease with the size of the issuance. These results suggest that
keiretsu members time the issuance of equity more so than stand-alone firms.
The study of the optimal boundaries of the firm has been a central question in finance and
economics since the seminal work of Coase (1937). Among other things, prior research has
examined the effect of conglomerate structure on corporate financing behavior. The literature
relying on US evidence has suggested two advantages in terms of financing activities for fully
integrated conglomerates relative to focused stand-alone firms. First, conglomerates may have
better access to external capital markets, especially when capital market conditions are not
favorable (Dimitrov and Tice, 2006). Second, conglomerates may substitute their internal capital
markets for costly external markets (Williamson, 1975; Stein, 1997; Yan 2006; Yan, Yang, and
Jiao, 2010). We propose a third advantage for Japanese conglomerates. Conglomerate member
firms may time external capital markets more so than stand-alone firms.
Japanese conglomerates, known as keiretsu, offer a hybrid structure between fully integrated
conglomerates and stand-alone firms. Although the member firms are separate legal entities that
are typically publicly traded and enjoy some degree of autonomy, they are closely related to
one another through a web of legal, economic, and personal relations. In addition, the member
firms are often associated with a main bank that is affiliated with the group. While this system
is a characteristic of Japan, it exists in comparable ways in other countries (e.g., South Korea).
This unusual structure has potential implications for the financial policy of its group members,
particularly in terms of their financing policies. More specifically, the valuation in equity markets
We thank Eric de Bodt, Bill Christie (editor), Sudipto Dasgupta, Armen Hovakimian, Chuan Yang Hwang, Jun-Koo Kang,
Clive Lennox, Laura Liu, Wei-Lin Liu, Peter McKay, Pascal Nguyen, Wei-Ling Song, Xueping Wu, Yishay Yafeh, An Yan, an
anonymous referee, and seminar participants at the 2006 International Banking and Finance Conference, the 2006 Asian
FA/FMA Conference, the 2006 FMA Annual Meeting, the 14th Conference on the Theories and Practices of Securities
and Future Markets, the 2007 EFA Annual Conference, the 2008 Asian FA Conference, Hitotsubashi University, Hong
Kong Baptist University, and Hong Kong Polytechnic University for their valuable comments on our manuscript. This
research was completed while Professor Hilary was on faculty at HKUST and HEC Paris. All remaining errors are ours.
Xin Chang is an Assistant Professor in the Division of Banking and Finance in the Nanyang Business School at Nanyang
Technological University, S3-B1A-17, Nanyang Avenue, Singapore 639798. Gilles Hilary is an Associate Professor in the
Department of Accounting at INSEAD, Fontainebleau, France, 77305. Chia Mei Shih, Citigroup and the Department of
Finance at the University of Melbourne, Melbourne, Australia, VIC, 3010. Lewis H.K. Tam is an Assistant Professor in
the Faculty of Business Administration at the University of Macau, Macau.
Financial Management

Winter 2010

pages 1307 - 1338
1308 Financial Management
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Winter 2010
of keiretsu members in dissimilar industries could be different. Some member firms could be
overpriced while others are underpriced at the same time. The keiretsu members can cooperatively
time the market for the group as a whole by issuing equity for its overvalued members and avoiding
equity financing for its undervalued ones. While it could be argued that all firms have incentives
to take advantage of favorable market conditions if they can, keiretsu members should have
greater incentive to do so as they can reallocate the funds obtained in periods of hot market
sentiment to the keiretsu members that may make more productive use of these funds, even if
these members do not have the same facility to raise funds. By construction, this is not feasible
for stand-alone firms.
1
Our empirical results are consistent with our expectations. We document a significant effect
of market timing on the capital structure of a general cross-section of publicly traded Japanese
firms. More importantly for our purposes, we find that the capital structure of firms that belong
to a conglomerate group is more affected by past market conditions than is the capital structure
of similar stand-alone firms. Keiretsu firms that timed the issuance of capital in the past have less
debt in their capital structure. The difference is both economically and statistically significant.
The change in the leverage ratio is also more sensitive to past stock returns for conglomerate
members than for stand-alone firms. Moreover, the decision of keiretsu firms to issue equity is
further correlated with market conditions than that of stand-alone firms. In a general cross-section
of firms, we find that stock returns following the issuance of equity decrease with the size of the
issue. Although this finding is not very statistically robust in a general cross-section of Japanese
firms, the correlation is stronger for firms that belong to a keiretsu than for stand-alone firms.
These results suggest that keiretsu members time the issuance of equity more than do stand-alone
firms, and that this timing behavior affects their capital structure to a greater degree.
We then consider the relationship among different members of keiretsu conglomerates and,
in particular, examine how firms use the proceeds from equity issuances. We find that firms
that time the market use the proceeds to repay their bank loans, thus having smaller amounts
of bank loans on their balance sheets than firms that do not time the market. More importantly,
these effects are stronger for keiretsu firms than for stand-alone firms, suggesting that firms
use the proceeds of equity issues, which were raised when equity market conditions are good,
to repay outstanding bank loans. This strategy magnifies the effect of equity timing on capital
structure because, aside from the addition of equity to the firms balance sheet, good equity
market conditions enable the retirement of bank debt. Finally, we find that the timing activity of
a given keiretsu member affects the capital structure of other keiretsu members. Specifically, our
results indicate a positive association between the market timing activity of a keiretsu member
and the average loan-to-assets ratio of other keiretsu members of the same conglomerate. This
last result is also consistent with the idea that keiretsu firms redeploy capital within the group
after issuing overvalued capital through the main bank. In contrast to the situation in many other
settings, the benefits of the market timing of equity issuance in Japan may go to creditors (i.e.,
the main banks) and to other group members, rather than solely to existing shareholders.
Our research contributes to the literature in at least two ways. First, it improves our understand-
ing of conglomerates. Although the costs and benefits of external and internal markets have been
studied (Scharfstein and Stein, 2000; Khanna and Tice, 2001), the effects of the hybrid keiretsu
structure are much less understood. As noted above, we use this unique setting to investigate
1
Our results are also consistent with the idea that greater market timing activity enables conglomerates to allocate internal
funds more optimally. This view is consistent with Yan Yang, and Jiao (2010) who find that investment in diversified
firms is less affected when external capital becomes more costly at the aggregate level. However, a thorough investigation
of this issue is outside the scope of our study.
Chang et al.
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Conglomerate Structure and Capital Market Timing 1309
an advantage of conglomerates that has not been evidenced by the prior literature. Additionally,
in sharp contrast to the situation in the United States where banks are prohibited from holding
stock in the firms that they lend to and where external financing transactions are conducted on
an arms length basis, keiretsu members have privileged access to the main bank associated with
the group. This allows us to consider the effects of conglomerate structure and banking relation-
ship on market timing. Thus, we investigate both the correlation between keiretsu members and
external equity markets and between keiretsu members and the main bank.
Second, our study offers new insights regarding the drivers of financing behavior. Leaving
aside their large size, considering the Japanese markets is helpful as it complements a recent body
of research exploring the market timing behavior of US firms. The literature has long suggested
that firms make securities issuance decisions based on the objective of maintaining either a target
capital structure (trade-off theory) or a financing hierarchy (the pecking order theory). A more
recent stream of research, however, observes the prevalence of establishing financing decisions
based on market conditions among US firms.
2
In turn, it has been argued that past market timing
decisions have a persistent effect on the capital structure of a firm (Baker and Wurgler, 2002;
Huang and Ritter, 2009). However, the existence and effects of market timing remain controversial
among scholars (Hovakimian, 2005; Kayhan and Titman, 2007), and, to date, there have been few
studies examining the market timing hypothesis of capital structure outside the US market. Our
study contributes to filling this gap.
The rest of this paper is organized as follows. In Section I, we review the market timing
literature and elaborate our hypotheses. Section II details our market timing variables. Section III
describes the selection and properties of our sample. Section IVpresents our main findings, while
Section V provides our conclusions.
I. Previous Literature and Hypothesis Development
A. Industrial Organization in Japan
The corporate structure environment in Japan is very different from the one in the United
States. In particular, it is characterized by two elements that are not present in Anglo-Saxon
countries. The first is the existence of industrial groups known as keiretsu. Douthett, Jung, and
Kwak (2004) describe keiretsu members as having close financial and personal ties with one
another, as well as with their banks, through cross-shareholdings, credit holding, interlocking
corporate directorates, and a variety of business transactions.
3
For example, Presidents Club
(shacho-kai) meetings are regularly scheduled among presidents of keiretsu firms (Douthett
and Jung, 2001). Although the firms in a keiretsu operate in different industries, they create
reciprocal voting rights and form coalitions. In doing so, the firms in a keiretsu can credibly
threaten management with demotion or termination, thus ensuring cooperation among various
keiretsu members (Bergl of and Perotti, 1994). While this system is characteristic of Japan, it
2
For example, in a survey of 392 US-based chief financial officers, Graham and Harvey (2001) report that 70% believe
that one of the most important considerations for equity issuance is the extent to which the stocks of their companies
are overvalued or undervalued at a given point in time. This suggests that managers take advantage of a window of
opportunity by timing their equity issues.
3
Keiretsu can be categorized into vertical (manufacturer-centered) and horizontal (bank-centered) groups. Keiretsu firms
are vertical if they are linked by customer-supplier relationships, and horizontal if they are linked by a main bank
system in which the main bank assumes a pivotal role in financing the investments of the keiretsu firms and readily helps
them out of financial distress should they require it. Following the prior literature (Weinstein and Yafeh, 1995; Wu and
Xu, 2005), we consider only horizontal groups and use the term keiretsu only in reference to these conglomerates.
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Winter 2010
exists in a comparable way in other countries (e.g., South Korea). Therefore, the implications
of our findings are not limited to Japan. In addition, one advantage in the use of this setting
to investigate the effect of corporate structure on economic activities is that this classification
is readily observable and largely exogenous. Distinct from many settings, this structure was not
caused by recent decisions; rather, it is largely driven by historical factors that go back to the
nineteenth century. The modern keiretsu are the successors of the nineteenth century industrial
groups (the zaibatsu) that were broken up after the World War II. Even though the perimeter of the
groups has evolved a little over time, the basic structure has not changed much. Therefore, we can
use membership as a partitioning variable that is not drastically influenced by recent investment
or financing decisions. The keiretsu literature primarily focuses on the effects of membership on
the return on investment and the cost of capital. However, to the best of our knowledge, the debate
regarding the benefits and costs of keiretsu affiliation has not been considered in the context of
capital market timing. Understanding the connection between membership and market timing
should, therefore, provide new insight into the financing behavior of conglomerates.
The second difference between Japan and the United States is the strong affiliation between
financial institutions and industrial companies. Of course, such relationships also exist in countries
other than Japan (e.g., Germany), but the intensity of these relationships is stronger in Japan than
in most other countries as firms that belong to keiretsu are linked by a main bank system in which
the main bank heavily influences the financing decisions of the member firms. Further, given that
the Japanese bond market is more limited than those in many other economies, Japanese firms,
even the larger ones, rely more heavily on bank financing than those in countries such as the
United States. Consistent with this idea, Pinkowitz and Williamson (2001) demonstrate that the
mean percentage ratio of bank debt to total debt is about 90% for their sample of Japanese firms.
At the same time, Japanese banks and financial institutions are allowed to invest in industrial
companies. In fact, our descriptive statistics (reported in Table I) indicate that equity ownership
by financial institutions represents approximately 30% of the total ownership of publicly traded
firms. The significance of this bank ownership provides a natural setting in which one can
investigate the effect of relationship banking on capital market timing.
B. Market Timing and Capital Structure
We consider the effect of the presence of conglomerates on market timing and capital structure
decisions. In an efficient market, stock prices fully incorporate all available information, and firms
expect to obtain a fair price for their securities offerings (Fama, 1970). Early theories of capital
structure, such as the trade-off theory and the pecking order theory, follow this assumption. In
this setting, there is no need to time the market as securities prices represent the true underlying
value of the firm. However, there is now a fairly large body of empirical evidence, including
the studies of Ritter (1991), Speiss and Affleck-Graves (1995), Loughran and Ritter (1997),
Graham and Harvey (2001), Gompers and Lerner (2003), and Burch, Christie, and Nanda (2004),
that documents the prevalence of firms scheduling their equity issuances when stock market
conditions are favorable to obtain cheap equity funds. This stream of research suggests that
firms may not always issue securities to satisfy immediate financing needs but may instead issue
equity at a time when share prices are high (compared with either the price of other forms of
capital or with the underlying value of the firm) simply to exploit the relatively cheap cost of
equity financing.
4
4
The literature typically focuses on equity (as opposed to debt) market timing. Although debt can also be mispriced, Barry
et al. (2008) indicate that US companies indeed issue more debt when interest rates are low and equity is more sensitive
to information asymmetry (Myers and Majluf, 1984) than debt; therefore, it is more likely to be severely mispriced.
Chang et al.
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Table I. Summary Statistics
Data are collected from the Pacific-Basin Capital Markets (PACAP) database for the years 1977-2004. The
table reports the summary statistics for the full sample and for subsamples classified by keiretsu affiliation,
where data on group affiliation come from Industrial Groupings in Japan. Total assets (A) is the book value
of total assets. Book leverage ratio (TDB) is the ratio of total liabilities to total assets. Market leverage ratio
(Lev) is total liabilities divided by (total assets book equity + market capitalization). Bank-loans-to-total-
assets (LOAN/A) and bank-loans-to-total-liabilities (LOAN/OLIB) ratios are self-explanatory and defined
in the Appendix. Profitability (ROA) is defined as the return on assets, which is taken as the income from
operations divided by total assets. Market-to-book-ratio (MB) is defined as (total assets book equity +
market capitalization) divided by total assets. Firmsize (SIZE) is the natural logarithmof net sales in millions
of yen. Tangibility (TANG) is defined as net fixed assets divided by total assets. Financial institutional
ownership (FinOwn) and business corporation ownership are obtained from the PACAP database.
Full Stand-Alone Keiretsu
Sample Firms Members
Total assets (A) Mean 225 194 283
Median 55 49 75
Book leverage ratio (TDB) Mean 0.62 0.60 0.67
Median 0.65 0.61 0.70
Market leverage ratio (Lev) Mean 0.50 0.48 0.54
Median 0.50 0.48 0.54
Bank loans-to-total liabilities (LOAN/A) Mean 0.22 0.20 0.25
Median 0.18 0.15 0.22
Bank loans-to-other liabilities (LOAN/OLIB) Mean 12.5 12.5 12.5

Median 1.73 1.40 2.25
Firm size (SIZE) Mean 11.0 10.8 11.3
Median 10.9 10.8 11.2
Profitability (ROA) Mean 0.042 0.044 0.038
Median 0.038 0.040 0.035
Market-to-book ratio (MB) Mean 1.42 1.44 1.39
Median 1.23 1.23 1.24

Tangibility (TANG) Mean 0.26 0.27 0.26
Median 0.24 0.24 0.24

Financial institutional ownership (FinOwn) Mean 31.5% 29.9% 34.5%
Median 31.0% 29.1% 35.0%
Business corporation ownership (BusOwn) Mean 30.1% 30.0% 30.4%
Median 26.1% 26.1% 26.1%
Number of firm years 40,136 26,387 13,749
Significant at the 0.01 level.

Building on this literature, Baker and Wurgler (2002) test the theory with their market timing
measure, the external finance weighted average market-to-book ratio (BWMB). This variable
takes a high value if external financing occurs in high market-to-book years. Baker and Wurgler
(2002) argue that BWMB should be inversely related to a firms leverage if the firm constantly
times the equity markets but does not rebalance its capital structure. Consistent with their predic-
tions, they find evidence of timing in the United States and the persistence of these timing effects
on capital structure. They suggest that current capital structures reflect the cumulative effect of
timing the equity markets in the past. Also consistent with this view, Huang and Ritter (2009)
note the long-lasting influence of past financing transactions on leverage as firms revert very
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Winter 2010
slowly to their optimal capital structure. Baker and Wurgler (2002) conclude that low leverage
firms are those that raised funds when their market valuations were high, as measured by the
market-to-book ratio, while high leverage firms are those that raised funds when their market
valuations were low.
Several studies (Hovakimian, 2005; Leary and Roberts, 2005; Kayhan and Titman, 2007; Liu,
2005) have built on this approach to refine the initial timing measure. These studies argue that
Baker and Wurglers (2002) timing measure actually reflects information about the historical
market-to-book ratio, which is related to the firms growth opportunities. As firms with higher
growth opportunities desire lower leverage ratios, the negative correlation between Baker and
Wurglers (2002) measure and the debt ratio can be attributed to firms adjusting their debt ratios
toward a target, rather than to timing activity. To address this issue, Kayhan and Titman (2007)
propose a decomposition of Baker and Wurglers (2002) timing measure that incorporates the
average past market-to-book ratio (a measure of growth opportunities) and the covariance between
issuance activity and the market-to-book ratio (a measure of timing activity). They argue that
the covariance term better captures the market timing behavior of firms. Using this alternative
measure, Kayhan and Titman (2007) demonstrate that the covariance term is negatively related
to the change in debt ratios, but at a lower economic magnitude than that found by Baker and
Wurgler (2002).
Further research has sought to understand the drivers of this behavior and the cross-sectional
determinants of the importance of capital market timing for capital structure and issuance de-
cisions. For example, Chang, Dasgupta, and Hilary (2006, 2009) find that the capital structure
of transparent firms is less sensitive to stock market conditions and transparent firms are less
affected by market conditions when they issue equity than opaque firms. However, little research
has been conducted regarding the additional drivers of market timing and, in particular, the effects
of organizational structure and relationship banking. Based on our prior discussion, we predict
that market timing should be more important for keiretsu members than for unaffiliated stand-
alone companies. More specifically, we expect the capital structure of keiretsu members to be
more affected by past market conditions than the capital structure of stand-alone firms. Relatedly,
we expect that keiretsu firms should be more sensitive to stock market conditions when they issue
equity than stand-alone firms.
C. The Use of the Proceeds from Market Timing
We also consider how firms use the proceeds of their capital issuance. Given that business
segments in a traditional US style conglomerate can cross-subsidize each other through internal
capital markets, we expect keiretsu groups may behave in a similar fashion. Unlike business
segments in a conglomerate, keiretsu members do not share the same fully integrated internal
capital markets. Nevertheless, they can redeploy capital to other members of the group through
at least two channels. The first is for the overpriced keiretsu members to raise money from
equity markets and pay off the loans borrowed from the group affiliated banks. In this way, the
keiretsu member banks can reallocate loans to the underpriced keiretsu members. The second
is for keiretsu members to cross-subsidize one another through direct equity investment. In this
case, the overpriced keiretsu members can raise money fromequity markets and transfer the funds
to the underpriced keiretsu members by investing in the equity of the latter.
Both channels are possible and not mutually exclusive. However, while there is a possibility
that some redeployment is done through equity investment, we focus on the first channel for three
reasons. The first reason is that using debt to transfer capital within the group is usually easier than
using equity. Loans can be easily repaid, but equity instruments are harder to issue and cancel.
Chang et al.
r
For example, a board decision is often required to modify firm capital, but no such decision is
typically needed when debt instruments are involved. Moreover, the buying and selling of equity
can have significant legal, regulatory, and accounting implications (e.g., the consolidation or not
of the investment), whereas changes in debt investments are much less likely to trigger these
effects. Second, debt financing is economically significant in Japan. Table I indicates that the
average ratio of total liability to the market (book) value of assets in Japan is 50% (62%) for the
years 1977-2004.
5
Over the same period, we estimated the corresponding average ratio of total
liability to the market (book) value of assets to be 41%(50%) for all American firms in Compustat.
Third, to be able to implement clean tests of the second channel, we would need a good measure
of the equity investment of each member in other group affiliates. Unfortunately, such level of
disaggregation is not available in our data set. In contrast, debt financing is typically concentrated
in Japan. The bond market is very small compared to the bank loan market (Pinkowitz and
Williamson, 2001), and at the firm level, loans are typically concentrated in the hands of the main
bank.
We expect keiretsu firms to utilize bank loans as an intermediary to redeploy the proceeds of
issuances that are opportunitistically timed to take advantage of favorable equity conditions. In
other words, when a keiretsu member issues overpriced equity, we expect it to use the proceeds
to pay back loans. The proceeds are then redistributed to other keiretsu members as new loans.
If these conjectures are correct, we expect, for all firms, past market timing activity to have an
effect on the amount of loans outstanding and, more importantly for our purpose, that this effect
will be stronger for keiretsu firms than for stand-alone firms. In addition, we predict a positive
correlation between past market timing activity of a keiretsu firm and the loan-to-assets ratio of
the keiretsu firm members other than the one that is timing the external capital market.
II. Market Timing Variables
We use three main proxies for market timing (Timing). The first is that proposed by Baker and
Wurgler (2002): BWMB or the external finance weighted average market-to-book ratio,
BWMB
t 1
=
t 1
s=0
EF
s
t 1
r=0
EF
r
(MB
s
) , (1)
where EF
s
and MB
s
denote the external financing (the sum of net debt and equity issued) and the
market-to-book ratio, respectively, at time s.
6
For each firm-year, we calculate the summations of
Equation (1) from the first year that financial data are available to the end of the previous year.
Following Baker and Wurgler (2002), the assigned weight for each year is bounded below at zero.
In other words, if EF is negative in a year, it is set to zero. BWMB takes on a high value if firms
raise external capital in the years in which their market-to-book ratio is high. To the extent that
a higher market-to-book ratio proxies for greater equity mispricing, Baker and Wurgler (2002)
argue that BWMB will be negatively related to leverage if firms issue equity in the year in which
the overvaluation occurred. This conjecture intuitively captures the notion of market timing.
5
The market value of assets is defined as total assets minus the book value of equity plus the market value of equity.
6
Following Baker and Wurgler (2002), we define the net debt and equity issuances using balance sheet data. The net
equity issuance is equal to the change in total equity minus the change in retained earnings, and the net debt issuance is
the change in total assets minus the net equity issuance. We define the market-to-book ratio as the quasi-market value of
assets divided by the total book value of assets. The details of the variable definitions are included in the Appendix.
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Winter 2010
The intuition is that for the same aggregate amount of external financing (EF), if a firm issues
more equity than debt when the market-to-book ratio is high, then the debt-to-assets ratio should
subsequently be lower. Thus, for companies timing the market more actively, there should be
a stronger negative relationship between the past external finance weighted market-to-book ratio
and the current leverage ratio.
7
In addition, firms can use the proceeds of equity issuances to
retire debt rather than paying dividends or investing in new projects. In this case, the effect of
equity issuance on capital structure should be even more pronounced.
Baker and Wurgler (2002) are aware that BWMB may also be a proxy for investment opportu-
nities, which would lead to a negative relationship between BWMB and leverage. Therefore, they
include the lagged one-period market-to-book ratio in their leverage regressions to control for
investment opportunities. However, Kayhan and Titman (2007) argue that Baker and Wurglers
(2002) control may be ineffective, and suggest the following decomposition of BWMB:
BWMB
t 1
=
t 1
s=0
EF
s
MB
s
t 1
r=0
EF
r
,
BWMB
t 1
t 1
r=0
EF
r
=
t 1
s=0
EF
s
MB
s
.
(2)
When scaling both sides by t
BWMB
t 1
EF =
_
t 1
s=0
EF
s
MB
s
_
_
t,
=
_
t1
s=0
EF
s
MB
s
_
_
t EF MB + EF MB,
= Cov (EF, MB) + EF MB.
(3)
Thus,
BWMB
t 1
=
Cov (EF,MB)
EF
+ MB = KTCOV
t 1
+KTMB
t 1
, (4)
where
KTCOV
t 1
=
Cov (EF, MB)
EF
and KTMB
t 1
= MB. (5)
As this decomposition illustrates, BWMB is simply the sum of KTCOV and KTMB, where
KTCOV is the covariance between external financing and the market-to-book ratio at t, scaled
by the average external financing. To the extent that the market-to-book ratio captures equity
7
BWMB represents a measure of capital market timing. The leverage ratios of firms with a similar BWMB will be different
if they issue different proportions of equity and debt when their valuation is higher. In addition, equity financing itself
will not affect the debt ratio if the firm also issues debt to rebalance the effect of equity financing. Therefore, the effect
of BWMB on the capital structure is a measure of equity market timing.
Chang et al.
r
mispricing, only KTCOV really captures the timing intuition of Baker and Wurgler (2002). The
second term, KTMB, is simply the historical average market-to-book ratio, which proxies for
investment opportunities. As such, we use KTCOV as our second proxy for market timing.
To further address the concern that MB may proxy for investment opportunities rather than
misvaluation, we use a third measure of market timing based on the methodology developed by
Rhodes-Kropf, Robinson, and Viswanathan (2005), which captures stock misvaluation by filter-
ing out growth opportunities. Specifically, Rhodes-Kropf, Robinson, and Viswanathan (2005)
decompose the logarithm of MB as follows:
8
Ln(MB)
i t
= m
i t
b
i t
= m
i t
v(
i t
,
j t
)
. ,, .
FSE
+v(
i t
,
j t
) v(
i t
,
j
)
. ,, .
T SE
+v(
i t
,
j
) b
i t
. ,, .
LRV
,
(6)
where m and b are logarithms of the quasi-market value of assets (M) and the book value of
assets (B), respectively. The subscripts, i, j, and t, denote firm, sector, and time, respectively. The
first term, the firm-specific pricing error (FSE), is the difference between the market value and
the fundamental value v(
i t
,
j t
) computed by using its firm-specific accounting multiples
it
and its sector j multiple
jt
measured at valuation year t. The second term, the time-series sector
error (TSE), measures the difference between a firms fundamental value conditional on both
contemporaneous accounting principles and its value as implied by its accounting information
and long-run multiples. This term captures the misvaluation of the whole sector at time t as
v(
i t
,
j
) measures sector-specific valuation, which does not vary over time. The third term,
LRV, concerns the difference between a firms valuation based on long-run multiples and its book
value, and captures its set of investment prospects at time t.
9
Having isolated the firm-specific misvaluation from the other components of market valuation,
such as industry-wide mispricing and fundamental growth prospects, we then define three new
external finance weighted average measures based on three components of the market-to-book
ratios, namely, 1) FSE, 2) TSE, and 3) LRV. To ensure that the averaged variables are positive,
8
Unlike Rhodes-Kropf, Robinson, and Viswanathan (2005) who use net income as the measure of accounting profitability
to decompose the market-to-book equity ratio, we use operating income instead to decompose the market-to-book assets
ratio for consistency.
9
More specifically, we estimate the model,
m
i t
=
0 j t
+
1 j t
b
i t
+
2 j t
ln(OI )
+
+
3 j t
I
(OI <0)
ln(OI )
+
i t
+
4 j t
TDB
i t
+
i t
,
where OI
+
stands for the absolute value of operating income and I
(OI<0)
is an indicator function for negative operating
income observations. Since the equation is estimated in logs and operating income can be negative, this specification
allows for operating income to enter into the estimation without discarding all firms with negative operating income at
a given point in time. The book leverage ratio (TDB) is included to allow for the fact that firms with a leverage that
is higher or lower than the industry average have a different value multiple. We group the firms according to the 11
Fama and French industries and run annual, cross-sectional regressions for each industry in question. v(
it
,
jt
) is the
fitted value from the regression equation, which proxies for the fundamental value of a firm i in sector j at time t. To
compute v(
it
,
j
), which is the long-run sector multiple, we average over time, for each industry, the estimated values
of the contemporaneous multiples to obtain
1
T

kj t
=
kj,
k = 0, 1, 2, 3, 4. Our results are essentially the same if the
timing-series average is taken over the period [1,t] rather than over the entire sample period. v(
jt
,
j
) is then computed
as,
v(
i t
,
j
) =
0 j
+
1 j
b
i t
+
2 j
ln(OI )
+
i t
+
3 j
I
(OI <0)
ln(OI )
+
i t
+
4 j
TDB
i t
.
This decomposition of the market-to-book ratio is described in greater detail in Rhodes-Kropf, Robinson, and Viswanathan
(2005).
r
Winter 2010
we use the exponential forms of the three components and compute the following three weighted
averages:
BWFSE
t 1
=
t 1
s=0
EF
s
t 1
r=0
EF
r
_
e
FSE
s
_
. (7)
BWTSE
t 1
=
t 1
s=0
EF
s
t 1
r=0
EF
r
_
e
TSE
s
_
. (8)
BWLRV
t 1
=
t 1
s=0
EF
s
t 1
r=0
EF
r
_
e
LRV
s
_
. (9)
The three external finance weighted average timing measures (BWFSE, BWTSE, and BWLRV),
which are based on three components of the market-to-book ratios, are comparable to those
in Kasbi (2007). Simple algebra indicates that Baker and Wurglers (2002) measure of market
timing (BWMB) can be written as the sum of BWFSE, BWTSE, and BWLRV. As FSE focuses
more on firm-specific mispricing than the market-to-book ratio does, we use the external fi-
nance weighted average firm-specific pricing error (BWFSE) as the third proxy for market
timing.
III. Sample and Summary Statistics
Our sample consists of Japanese firms in the Pacific-Basin Capital Markets (PACAP)
database from 1977 to 2004. Financial firms and firms with missing or negative book val-
ues of assets are excluded. We obtain the financial, stock market, and ownership struc-
ture data of the sample firms from PACAP and exclude firms that have missing data
on stock prices, equity issues, or debt issues. This results in a sample of approximately
40,000 firm-year observations. All of the variables are winsorized at the 0.5% level on both
sides of the distribution to reduce the impact of outliers or wrongly recorded data on our
results.
Firms in the sample are partitioned according to their keiretsu affiliation (K). The keiretsu
classification is obtained from different versions of Industrial Groupings in Japan, a publication
by Dodwell Marketing Consultants and Brown & Company Ltd.
10
Consistent with Weinstein and
Yafeh (1995) and Wu and Xu (2005), firms are classified as being affiliated with a keiretsu if
they are members of the six largest horizontal keiretsu groups, namely, DKB, Fuyo, Mitsubishi,
10
We use the 1992/1993, 1996/1997, 1998/1999, and 2000/2001 editions to identify the keiretsu affiliation. As the
affiliations are stable over time, we use the 1992/1993 edition to identify keiretsu affiliation before 1993 and the
2000/2001 edition for 2001 and after.
Chang et al.
r
Mitsui, Sanwa, and Sumitomo. This classification is largely a constant throughout our sample.
Of the 478 firms that were classified as keiretsu members in 1991, 433 (90.5%) were classi-
fied as members in 1996, 419 (87.7%) in 1999, and 404 (84.5%) in 2001. To further ensure
that our results are not driven by an endogenous relationship between financing decisions and
keiretsu membership, we reestimate the various measures and equations using only observa-
tions for which the keiretsu membership has not changed over time, and all of the results still
hold.
Aside from identifying the members of a keiretsu, Industrial Groupings in Japan also evaluates
the degree of integration of the firms in the group and partitions the keiretsu members into
four groups based on their group integration. Among all criteria, equity ownership by other
group members is the most important variable in determining group integration.
11
We create
an indicator variable for group affiliation (I) that equals one if a firm belongs to the two most
integrated categories reported in the Industrial Groupings in Japan and zero if it belongs to the
two least integrated categories.
Table I reports the descriptive statistics of the key variables for the whole sample and for
the two subsamples distinguished by keiretsu affiliation. The definitions of the variables are
included in the Appendix. We consider different alternative measures of financial leverage such
as the market leverage ratio (Lev), the book leverage ratio (TDB), the bank-loans-to-assets ratio
(LOAN/A), and the bank-loans-to-other-liabilities ratio (LOAN/OLIB). The market-to-book ratio
(MB), assets tangibility (TANG), profitability (ROA), and firm size (SIZE) are employed by Rajan
and Zingales (1995) and Baker and Wurgler (2002), who find them to correlate significantly with
leverage.
12
The summary statistics indicate that firms belonging to a keiretsu are generally larger (in
terms of total assets and sales (SIZE)) than stand-alone firms and also have lower firm valuation
(MB) and profitability (ROA). They have more debt (Lev and TDB) in their capital structure
and use more bank loans (LOAN/A and LOAN/OLIB). Finally, keiretsu firms also have a higher
percentage of their ownership controlled by financial institutions (FinOwn) and industrial firms
(BizOwn) than stand-alone firms. This result is consistent with the finding of Douthett, Jung, and
Kwak (2004) that firms in keiretsu are linked by a main bank system through cross-shareholdings
among members. Further, an (untabulated) analysis reveals that financial institutional owner-
ship (FinOwn) is negatively related with the bank-loans-to-assets ratios of keiretsu members
in general (the correlation coefficient is 0.1). This suggests that the main bank controls the
core members of the keiretsu by the importance of their loans, rather than through direct equity
ownership.
Table II reports the correlation coefficients among the key variables. Most of the univariate
correlations for the control variables (TANG, ROA, MB, and SIZE) are reasonably low, sug-
gesting that multicollinearity is not an issue in our setting. In addition to the expected strong
correlation between the book leverage ratio (TDB) and the market leverage ratio (Lev), we find
a negative relationship between the market-to-book ratio (MB) and the market leverage ratio
(the association between the market-to-book ratio and the book leverage ratio is also negative,
but much less significant). As expected, our various measures of market timing are positively
correlated.
11
In particular, the publication uses the ratio of the groups total interest in the firm to the total equity ownership of the
top 10 shareholders to classify keiretsu firms into four groups.
12
As a robustness check, we measure firm size as the log of market capitalization instead of net sales and find that our
results are essentially unchanged (untabulated).
r
Winter 2010
T
a
b
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.
Chang et al.
r
IV. Empirical Results
A. The Effect of Market Timing and Keiretsu Membership on Capital Structure
1. The Sensitivity of Capital Structure to Past Equity Prices
We first consider the impact of market conditions on capital structure and how keiretsu af-
filiation affects this relationship. Our first test is based on the intuition proposed by Baker and
Wurgler (2002) and Kayhan and Titman (2007). Specifically, we estimate
Lev
i,t
= a +
1
Timing
i,t 1
+
2
K
i,t 1
+
3
Timing
i,t 1
K
i,t 1
+ yX
i,t 1
+IND +
i,t
.
(10)
We regress the amount of debt in the contemporary capital structure (Lev) on measures of past
market timing (Timing), an indicator variable (K) that equals one if a firm belongs to a keiretsu
and zero otherwise, and the interaction term Timing K. We predict that the coefficient on the
market timing variables should be negative if the capital structure of Japanese firms is affected
by market timing activity, and should be more negative for keiretsu members than for stand-
alone firms.
13
In other words, we expect both coefficients,
2
and
3
, to be negative. We also
include the same vector of control variables (X) employed by Rajan and Zingales (1995) and
Baker and Wurgler (2002), specifically, the market-to-book ratio (MB), assets tangibility (TANG),
profitability (ROA), and firm size (SIZE). Frank and Goyal (2009) find that MB, TANG, and ROA
are the more reliable variables for explaining market leverage among a long list of factors
that affect financial leverage. The market-to-book ratio (MB) potentially proxies for investment
opportunities and should, according to the trade-off theory, be negatively related to leverage.
Asset tangibility (TANG) should be positively associated with leverage, given that tangible assets
indicate a better debt capacity. Profitability should increase the availability of internal funds
and, hence, reduce the need for debt financing. Therefore, ROA should be negatively related to
leverage. Following Frank and Goyal (2003) and Lemmon and Zender (2010), who find that large
firms are more reliant on debt financing than small companies due to greater debt capacity, we
expect firm size to be positively related to the leverage ratio. Finally, we also include a set of
industry indicator variables (IND) to control for industry effects.
Table III presents our results based on the estimation of Equation (10). We use three measures
of past market timing. In Column (1), we use the variable proposed by Baker and Wurgler (2002),
in Column (2), we focus on the variable proposed by Kayhan and Titman (2007), while in Column
(3), we consider the measure constructed based on the methodology proposed by Rhodes-Kropf,
Robinson, and Viswanathan (2005). In all of the reported specifications, the dependent variable
is the market leverage ratio (Lev).
Throughout this paper, we estimate all of the specifications using a modified version of
the Fama and McBeth (1973) procedure, similar to that used by Baker and Wurgler (2002).
14
Specifically, we run the yearly regression based on the number of years since the first year that
13
As a robustness check, we split the sample into keiretsu firms and nonkeiretsu firms, run separate regressions for the
debt ratios, and compare the coefficient of the market timing variable between the groups, but this approach leads to the
same conclusion as the one we report here.
14
The exceptions are Table IVand VI, in which we consider the stock returns. In this case, we use both the traditional Fama
and MacBeth (1973) approach and a pooled sample approach in which we correct the standard errors of the estimated
coefficient for heteroskedasticity and the clustering of observations by both firm and period (Cameron, Gelbach, and
Miller, 2006).
r
Winter 2010
Table III. The Sensitivity of Capital Structure to Market Conditions
The dependent variable is the Market leverage ratio (Lev), which is defined as the ratio of total liabilities to the
market value of assets. Three market timing measures are used to explain Lev. BWMBis the external finance
weighted average market-to-book ratio of Baker and Wurgler (2002). KTCOV and KTMB are obtained
according to Kayhan and Titmans (2007) decomposition of BWMB. BWLRE, BWTSE, and BWFSE are the
external finance weighted average LRV, TSE, and FSE, respectively, and LRV, TSE, and FSE are defined
according to Rhodes-Kropf, Robinson, and Viswanathan (2005). All of the other explanatory variables are
as defined in Tables I and II. The explanatory variables are lagged one period relative to the dependent
variable. A constant term and industry dummies are included in the regressions, but not reported. The model
is estimated using Baker and Wurglers (2002) modified Fama and MacBeth (1973) procedure based on the
number of years since the IPO.
(1) (2) (3)
Timing = BWMB Timing = KTCOV Timing = BWFSE
MB 0.091
0.088
0.087
(18.0) (18.8) (20.0)

TANG 0.033
0.033
0.101
(1.8) (1.8) (9.7)

ROA 1.368
1.394
0.578
(23.2) (23.8) (9.4)

SIZE 0.012
0.011
0.012
(4.4) (3.9) (6.8)

K 0.109
0.053
0.016
(12.0) (10.5) (6.1)

Timing 0.085
0.105
0.120
(8.9) (8.2) (14.0)

K Timing 0.048
0.017
0.071
(9.9) (3.1) (8.2)

KTMB 0.088
(9.8)
BWTSE 0.127
(4.7)
BWLRV 1.138
(30.5)
Constant 0.821
0.837
0.790
(19.9) (19.2) (21.7)

Observations 40,136 40,136 40,106
R
2
0.47 0.47 0.60

there is stock price information on the firm in PACAP rather than using calendar years. The
reported coefficients are then based on the average value of the yearly coefficients, and the
t-statistics are calculated using the standard errors of the estimated coefficients. This approach
allows us to address the potential cross-correlation in error terms for firms of a similar age.
Our conclusions hold when we use the traditional Fama and MacBeth (1973) approach and a
pooled sample approach in which we correct the standard errors of the estimated coefficient for
heteroskedasticity and the clustering of observations by both firmand period (Cameron, Gelbach,
and Miller, 2006). This last specification simultaneously addresses the issues of serial correlation
and that of the cross-correlation of error terms in a given period.
Chang et al.
r
All of the columns indicate that the capital structures of Japanese firms are influenced by past
equity market conditions with BWMB, KTCOV, and BWFSE all being statistically significant.
The effect is also economically significant. For example, in untabulated regressions, we drop the
interaction terms with K to estimate the unconditional effect of the proxies for market timing. We
find the coefficients associated with BWMB, KTCOV, and BWFSE to be economically large. An
increase in one standard deviation of BWMB leads to a reduction of approximately 11.3% in the
average value of Lev, and the corresponding values for KTCOV and BWFSE are 11.6% and 5.3%.
These results suggest that the market timing theory of capital structure is not uniquely applicable
to the US setting. When we consider the interaction of K with the measure of market timing, we
observe that market timing is more important for keiretsu members than for stand-alone firms.
We reach this conclusion irrespective of the proxy for market timing used. The economic effect
is such that the effect of BWMB and BWFSE is increased by approximately 60%, whereas the
effect of KTCOV is increased by approximately 15%. The control variables have the expected
signs, although the statistical significance of TANG is low in the first two columns.
We then reproduce this specification (Equation (10)) with only the keiretsu members and
examine the effect of group integration on the importance of market timing. We employ an
indicator variable for group affiliation (I) that equals one if a firm belongs to the two most
integrated categories reported in the Industrial Groupings in Japan and zero if it belongs to the
two least integrated categories. We find that the impact of market timing on capital structure
is stronger for closely affiliated keiretsu members (I = 1) than for loosely affiliated members
(I = 0). For example, untabulated results indicate that when we restrict our sample to keiretsu
members and substitute I for K, the interaction between I and our three measures of market
timing is significantly negative (with t-statistics ranging from 3.4 for I BWMB to 5.8 for
I BWFSE).
These results are also robust to alternative econometric specifications. For example, they hold
when we use the book leverage ratio (TDB) as the dependent variable, and also when we use a
split-sample approach and test the differences in coefficients among the groups. They hold when
we use firm (instead of industry) fixed effects, and also if we add an interaction between BWTSE
and K in the model reported in Column (3) (as BWTSE and BWFSE have a zero correlation by
construction). In this last case, K BWTSE is negative and significant (with a t-statistic equal to
2.7), whereas BWTSE remains significant (with a t-statistic equal to 4.5). We also find that
our various results hold for both the pre-1990 and post-1990 periods, suggesting that they are not
driven by a time-series effect but rather by cross-sectional differences.
2. The Sensitivity of Capital Structure to Stock Returns
We then examine the impact of stock returns on the change in capital structure. In other words,
we revisit our results from Table III but condition our analysis on the change in price rather than
the price level. To do so, we regress the change in the market leverage ratio on stock returns
over the same period. We consider three periods (from t 5 to t, from t 3 to t, and from
t 1 to t), and measure stock returns using CSR. CSR is the cumulative stock returns defined as
the holding-period return over the 12 months prior to the beginning of the current fiscal year. We
include the same explanatory variables as in Table III but use changes instead of levels (MB,
TANG, ROA, and SIZE). We also control for the impact of the target leverage ratio on
financing decisions using the approach outlined in Hovakimian, Opler, and Titman (2001) who
examine the debt-equity choice. Specifically, our estimation procedure involves two stages. In the
first stage, the debt-to-assets ratio is regressed on the vector of control variables (X) in Equation
(10), together with the year and industry indicator variables. The purpose of this first stage is to
r
Winter 2010
provide an estimate of each firms optimal or target leverage ratio. As the dependent variable in
the first-stage regression is, by definition, censored both below (by the value of zero) and above
(by the value of one), to obtain consistent estimates, we estimate the Tobit regression with this
double censoring. We then calculate the deviation fromthe target (DEVI) by subtracting the target
debt ratio at time t j from the actual debt ratio at time t j. In the second stage, we estimate the
following OLS regression:
Lev
i,[t j,t ]
= +
1
CSR
i,[t j,t ]
+
2
K
i,t 1
+
3
CSR
i,[t j,t ]
K
i,t 1
+ X
i,[t j,t ]
+DEVI
i,t j
+
IND +
i,t
.
(11)
If Japanese firms time their equity issuances, then we would expect a negative relation between
stock returns and the change in leverage ratio. Similarly, if keiretsu firms time their securities
issuances more than stand-alone firms, then we would expect a more negative relationship for
these firms. We use the traditional Fama and MacBeth (1973) approach and report the results in
Table IV.
Consistent with the predictions, we find that CSR has a significantly negative impact on
the change in leverage ratio, with t-statistics ranging from 17.9 to 6.8. More importantly
for our purposes, this effect is more significant for keiretsu firms than for stand-alone firms
(the t-statistics associated with the interaction between K and CSR range between 3.9 and
3.2).
15
These results are consistent with the results from the specifications in levels reported in
Table III.
B. Equity Issuance and Stock Returns
Having established that the effect of market conditions on capital structure is more significant
for firms with a keiretsu affiliation than for stand-alone firms, we next consider the related issue
of the effect of market conditions on equity issuance. We consider two tests to investigate this
issue.
1. Stock Price Run-Up and External Financing
Previous studies (Loughran and Ritter, 1997) find that there is a significant stock price run-up
before a seasoned equity offering. We revisit this issue by regressing an indicator variable for
equity issuance on past stock returns and other control variables. To test whether the correlation
between previous price run-ups and equity issuances documented in the US setting also exist in
Japan, we again follow the approach by Hovakimian, Opler, and Titman (2001) (outlined above),
which explicitly controls for the impact of target leverage ratio on financing decisions. After
estimating the first-stage model, we use a probit regression that predicts a firms choice between
debt and equity issuance in a given year using the following equation:
P[Issue
i,t
= 1] = F(a +
1
CSR
i,t 1
+
2
K
i,t 1
+
3
CSR K
i,t 1
+
4
DEVI
t 1
+yY
i,t 1
+ IND),
(12)
15
As robustness checks, we use the change in book leverage ratio (TDB) as the dependent variable and control for the
change in market value of equity in the regressions and find that our results still hold (untabulated).
Chang et al.
r
Table IV. The Sensitivity of Capital Structure to Stock Returns
The dependent variable is the j year (j = 1, 3, or 5) change in the leverage ratio, which is defined as the
Market leverage ratio (Lev) at time t minus Lev at t j. The change in the market-to-book ratio (MB),
change in asset tangibility (TANG), change in profitability (ROA), and change in firm size (SIZE) are
measured over the same period. The initial deviation from the target is defined as Lev at t j minus the
target Lev at t j, where the target Lev is estimated by regressing Lev on MB, TANG, ROA, SIZE, Keiretsu
affiliation (K), year dummies, and industry dummies and taking the fitted value. The cumulative stock
return (CSR) is the holding period stock return over the same period. Industry dummies are included in the
regressions but not reported. The model is estimated using the Fama and MacBeth (1973) procedure based
on calendar year.
(1) (2) (3)
[t 1,t] [t 3,t] [t 5,t]
MB 0.025
0.042
0.051
(6.2) (9.1) (10.8)

TANG 0.135
0.020 0.008
(7.9) (1.5) (0.4)
ROA 0.322
0.478
0.559
(18.8) (23.9) (23.3)

SIZE 0.091
0.108
0.101
(26.4) (25.1) (16.8)

Deviation from target (DEVI) 0.030
0.073
0.116
(8.4) (14.0) (19.4)

K 0.001 0.004
0.004
(0.9) (3.3) (2.0)

Cumulated stock return (CSR) 0.136
0.110
0.094
(17.9) (8.9) (6.8)

K CSR 0.011
0.014
0.014
(3.9) (3.4) (3.2)

Constant 0.005 0.016
0.053
(1.5) (2.5) (4.0)

Observations 40,136 35,749 32,051
R
2
0.71 0.68 0.65

where P stands for the probability of equity being issued, and Issue is an indicator variable that
takes the value of one if the net equity issued constitutes more than 1% of the total book value
of assets and zero if the net debt issued exceeds 1% of the total assets. Only issue years in which
a firm issues net debt or equity in excess of 1% of the book value of assets are considered;
years in which both are issued or neither is above the 1% cutoff are excluded from the regression
analysis.
16
Following Baker and Wurgler (2002), we define the net equity issuance as the change
in total shareholder equity minus the change in retained earnings according to balance sheet items,
and net debt issuance as the change in total liability. K is the previously defined indicator variable
for keiretsu affiliation. As noted above, CSR is the cumulative stock returns over the 12 months
16
We set the 1% cutoff for the issue size to mitigate the impact of extremely small issues on our results. As in Hovakimian,
Opler, and Titman (2001), we replicate our tests using a 5% cutoff for the issue size, and our main results still hold.
r
Winter 2010
prior to the beginning of the current fiscal year. K CSR represents the interaction between
these two variables. We expect a positive relationship between the probability of issuance and
past stock returns if firms are engaged in market timing. If firms belonging to a keiretsu time
the market to a greater extent, then the coefficient for the interaction term between the proxy
for keiretsu affiliation and past returns should be positive. Y represents a vector of the control
variables. We include the variables used in the capital structure regressions (MB, TANG, ROA,
and SIZE), and also the set of control variables suggested by Hovakimian, Opler, and Titman
(2001), which comprises DMB, DROA, Maturity, and DEVI. DMB is an indicator variable that
takes the value of one if the market-to-book ratio is greater than one and zero otherwise. DROA
is an indicator variable that takes the value of one if the earnings before interest and taxes (EBIT)
are negative and zero otherwise. Maturity is the short-term debt to long-term debt ratio. DEVI
is equal to the difference between a firms lagged leverage ratio (Lev
t1
) and its estimated target
leverage, estimated from the first-stage regression.
17
Table V reports the results of the analysis
of the debt-equity choice conditional on past price behavior.
The results indicate that equity financing decisions of Japanese firms are sensitive to market
conditions, as the coefficients associated with MB and CSR are both significantly positive (with t-
statistics equal to 6.2 and 9.4, respectively). The economic significance of CSR on the probability
of equity issue is that an increase of one standard deviation in CSR raises the probability of an
equity issue by 2.7% (to put things in perspective, the unconditional probability of an equity
issue is 15.4%).
18
More importantly, firms with a keiretsu affiliation are more likely to issue
equity after a price run-up than stand-alone firms. The coefficient associated with the interaction
term between K and CSR is significantly positive with a t-statistic equal to 2.1. However, Ai and
Norton (2003) indicate that the interaction effect cannot be evaluated simply by looking at the
sign, magnitude, or statistical significance of the coefficient on the interaction term when the
model is nonlinear, but requires the computation of the cross derivative or cross difference. As
with the marginal effect of a single variable, the magnitude of the interaction effect depends on all
of the covariates in the model. In addition, it can have different signs for different observations,
making simple summary measures of the interaction effect difficult to formulate. To address this
issue, we use the procedure proposed by Norton, Wang, and Ai (2004) and present in Figure 1
a graphical representation of the distribution of the marginal effect (Graph A) and its statistical
significance (Graph B). Graph A indicates that the effect is always positive (the untabulated
mean value is.023), whereas Graph B confirms that the effect is significant for nearly all cases
(the mean value of the z-statistic is 2.32). Finally, we note that the effect of keiretsu affiliation
is insignificant. These results are again consistent with the idea that Japanese firms time the
issuance of their equity and that this behavior is more pronounced for keiretsu members.
As mentioned above, we exclude firm years in which both equity and debt are issued or neither
is issued because we focus on the debt-equity choice (conditional on issuance) in this regression.
17
DMB, DROA, Maturity, and DEVI are included to be consistent with Hovakimian, Opler, and Titman (2001). DMB is
added to address the concern that an equity issue will dilute a firms book value per share if the market-to-book ratio
exceeds one. DROA is employed to capture the financing choice of loss-making companies. Debt maturity is included
to control for the transfer of wealth from equity holders to debtholders that can occur when new equity is issued. Myers
(1977) suggests that the transfer of wealth is larger in firms financed primarily with long-term debt. Our results also hold
if we use only MB, TANG, ROA, and Size as the control variables (as in our first series of tests).
18
The marginal effect of CSR on the probability of equity issue, valued at the mean value of CSR, is 0.058. In other words,
if CSR increases 100% from the mean, then the probability of equity issue will increase by 5.8%. The standard deviation
of CSR is 45.9%. Therefore, an increase of one standard deviation in CSR will lead to a 0.058 0.459 = 2.7% increase
in probability.
Chang et al.
r
Table V. Market Conditions and Probability of Equity Issuance
The dependent variable is an indicator of equity issues (Issue) that is equal to one if the equity issued (E)
is greater than 1% of the total assets, but the debt issued (D) is less than 1% of the total assets, and zero
if the debt issued (D) is greater than 1% of the total assets, but the equity issued (E) is less than 1%
of the total assets. A probit model is estimated for the effect of the indicator on the explanatory variables.
The annual stock return (CSR) is the holding period stock return over the 12 months prior to the end of
fiscal year t. Debt maturity is defined as short-term debt / (short-term debt +long-term debt). The deviation
from the target is Lev at t 1 minus the target leverage ratio. The target leverage ratio is the fitted value of
the regression where the leverage ratio is regressed upon the vector control variables employed by Baker
and Wurgler (2002), together with the year and industry dummy variables. All of the other explanatory
variables are as defined in Table I and are lagged one period relative to the dependent variable. A constant
term is included in the regressions but not reported. The z-statistics in parentheses are calculated from the
Huber/White/sandwich heteroskedastic consistent errors, corrected for correlation across observations for
a given firm.
Equity vs. Debt Issuance
MB 0.118
(6.2)
Dummy for MB > 1 0.495
(13.8)
TANG 0.149
(1.5)
ROA 1.966
(4.8)
Dummy for ROA < 0 0.211
(3.9)
SIZE 0.012
(1.1)
Debt maturity 0.349
(7.1)
Deviation from target (DEVI) 0.711
(6.8)
K 0.012
(0.4)
CSR 0.274
(9.4)
K CSR 0.098
(2.1)
Constant 1.844
(7.9)
Observations 18,048
Pseudo R
2
0.05

Since this truncation could potentially generate a sample selection problem, in a robustness check,
we estimate a probit model with a nonrandom sample selection in which the financing policy is
modeled as a two-stage decision. In the first stage, a firm decides whether to raise external funds
or to use internal funds. In the second stage, firms that have chosen to raise external funds decide
whether they issue debt or equity. Following Chang, Dasgupta, and Hilary (2006, 2009) and Leary
and Roberts (2010), we include variables in the first stage that are likely to affect the companys
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Winter 2010
Figure 1. The Marginal Effect of the Interaction Effect in Table V
The two charts are plotted using the procedure proposed by Norton, Wang, and Ai (2004). Chart A presents
a graphic representation of the distribution of the marginal effects of the interaction term, K CSR, in
Table V. Chart B plots the statistical significance of the interaction term.
Chang et al.
r
requirement for external funds. Untabulated results indicate that the estimated coefficients and
the t-statistics are very similar to the tabulated results.
19
2. External Financing and Future Stock Returns
Recent studies by Fama and French (2008), Pontiff and Woodgate (2008), and McLean, Pontiff,
and Watanabe (2009) document the significantly negative impact of share issuance on future
stock returns. Pontiff and Woodgate (2008) determine that the share issuance effect on stock
return is statistically stronger than the predictability attributed to size, book-to-market ratio, and
momentum, and is hardly explained by risk-based explanations. McLean, Pontiff, and Watanabe
(2009) examine the share issuance effect for 41 counties and document a similar finding. In
particular, they find that the effect is stronger in countries with greater issuance activity, more
developed stock markets, and stronger investor protection. Their findings suggest that firms
facing lower issuing costs are more capable of timing the market, and that the market may fail to
correct mispricing immediately. If this is true, and if keiretsu members have a greater capacity to
time the market, the above-mentioned share issuance effect may be stronger for these firms than
for stand-alone firms. To examine this possibility, we relate the postoffering returns in year t to
the size of equity issue in year t 1 by estimating
FSR
[t,t +n]
= a +
1
(E
t
/A
t 1
) +
2
K
i,t
+
3
(E
t
/A
t 1
)
K
i,t
+ yZ
i,t 1
+ IND +
i,t
,
(13)
where FSR is the cumulative future stock returns subsequent to equity issues. We measure future
returns up to three years after an issuance. E/A is the size of the equity issue measured as
the amount of equity issued from t 1 to t scaled by the total assets at the beginning of the
period. K is our previously defined indicator variable and K E/A is the interaction between
the size of equity issue and K. If a firm times the equity market by issuing more equity when
equity is overvalued, then we would expect to observe a negative correlation between future stock
returns (FSR) and the size of equity issues (E) if the misvaluation is subsequently corrected. If
this relation is stronger for keiretsu firms than for stand-alone firms, then we would expect the
coefficient associated with K E/A to be negative. We also control for a vector of variables Z
that includes market capitalization as a proxy for size, the book-to-market ratio of equity, and the
holding-period stock return over the previous 12 months to capture the momentum effects. We
detail the definitions of these variables in the Appendix. We also include TANG and ROA as in
our previous specifications.
Table VI reports the analysis of the association between the size of equity issue (E/A) and
future stock returns. The dependent variable is the future 12-month holding period stock return
measured from the end of fiscal year t to t + k. We consider t + 1, t + 2, and t + 3. Most
of our regressions are estimated using the modified version of the Fama and McBeth (1973)
specification based on IPO age. However, this approach is not appropriate in this specification
as the serial correlation and cross-correlation by period of the error terms are likely to be more
important issues than the cross-correlation by age of the firms. Therefore, instead of using
19
We find that the statistic, which measures the correlation between errors terms of the equations in the two stages,
is equal to 0.09 and is significant at the 5% level. This suggests that the results given by the standard probit models
may be biased. However, given that the estimates using the two methods are qualitatively similar, we prefer to emphasize
the results from the simpler probit estimation. The results obtained using the two-stage probit model with the sample
selection is not tabulated, but is available upon request.
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Winter 2010
Table VI. Past Equity Issuance and Future Stock Returns
The dependent variable is the future 12-month holding period stock return (FSR) starting from the end
of fiscal year t. The independent variables include a firms market capitalization (MKTCAP), book-to-
market ratio (BTM), stock beta (Beta), stock turnover (Turnover), annual stock return (CSR), book-leverage
ratio (TDB), equity issue size (E/A), the keiretsu dummy (K), year dummies, and industry dummies.
Beta is computed as the coefficient of the market return in the regression in which the weekly individual
stock returns are regressed upon the returns on the value weighted market index over a 52-week period.
Turnover is defined as the mean value of monthly shares traded (volume) divided by shares outstanding over a
12-month period. Industry dummies are included in the regressions, but not reported. The model is estimated
using OLS (Columns (1)(3)) and the Fama and MacBeth (1973) procedure based on calendar years
(Columns (4)(6)).
Pooled OLS Adjusted for 2-way
Clustering
Fama and MacBeth
(1973)
(1) (2) (3) (4) (5) (6)
[t, t+1] [t, t+2] [t, t+3] [t, t+1] [t, t+2] [t, t+3]
Ln(MKTCAP) 0.025
0.056
0.079
0.020
0.038
0.058
(13.9) (14.6) (13.4) (1.8) (2.1) (2.1)

Ln(BTM) 0.072
0.161
0.204
0.058
0.106
0.148
(18.0) (19.3) (16.2) (3.9) (3.6) (3.7)

Beta 0.095
0.180
0.349
0.013 0.045 0.073

(17.9) (18.9) (24.5) (0.5) (1.4) (1.5)
Turnover 0.327
0.709
0.836
0.269
0.528
0.862
(5.5) (6.1) (5.0) (2.6) (3.9) (4.5)

CSR 0.053
0.106
0.117
0.055
0.078
0.079
(8.2) (9.1) (7.2) (2.5) (2.7) (2.6)

TDB 0.141
0.287
0.481
0.105
0.172
0.234
(9.1) (8.8) (9.5) (2.4) (2.5) (2.6)

TANG 0.131
0.233
0.449
0.052 0.083
0.086
(7.0) (5.7) (7.1) (1.6) (1.8) (1.3)
ROA 0.632
1.096
2.491
0.385
0.469
0.589
(9.2) (7.6) (11.7) (2.6) (2.0) (2.2)

K 0.018
0.038
0.077
0.010 0.022 0.033
(3.8) (4.0) (5.3) (1.6) (1.6) (1.9)

E/A 0.267
0.900
1.272
0.278 0.225 0.389

(2.0) (3.9) (5.4) (1.6) (0.8) (1.0)
K E/A 0.590
0.775
1.024
0.176 0.569
1.454
(2.9) (2.3) (2.8) (0.8) (1.7) (2.3)

Constant 0.414
1.053
1.157
0.335
0.619
0.906
(16.3) (14.6) (11.8) (2.3) (2.6) (2.4)

Observations 38,262 36,175 34,187 38,262 36,175 34,187
R
2
0.04 0.07 0.10 0.16 0.18 0.19

the IPO age approach, we use a pooled specification with industry fixed effects and correct
for heteroskedasticity and the simultaneous clustering of observations by firm and by period
(see Columns (1)-(3)). As an alternative, we also use the traditional Fama and MacBeth (1973)
approach (see Columns (4)-(6)).
Chang et al.
r
We find that when we control for standard risk proxies, E/Ais negatively related to future stock
returns.
20
However, the negative effect of equity issuance on future stock returns is statistically
more significant in the pooled regressions (in which the t-statistics adjusted for the clustering of
observations both by firm and period range from 2.0 to 5.4) than in the Fama and MacBeth
(1973) approach (in which the t-statistics range from 0.8 to 1.6). More importantly, this
relationship is more significant for firms with a keiretsu affiliation. The t-statistics for the
interaction between K and E/A are again higher in the pooled specification (with t-statistics
ranging from 2.3 to 2.9) than in the Fama and MacBeth (1973) specifications, but the effect
remains statistically significant in this case (at least when we consider t + 2 and t + 3). The
sensitivity of one-year future stock returns on equity issuance for keiretsu firms is equal to 0.857
(=0.267 0.590), which is more than twice as large as it is for stand-alone firms ( =0.267).
For a robustness check, we use the calendar-time portfolio approach to test the correlation
between equity issuance size and future stock returns. Mitchell and Stafford (2000) determine
that the pooled regression analysis of long-term stock returns leads to an inflation of t-statistics
as the cross-correlations among overlapping return series are not well accounted for. In addition,
Fama (1998) suggests that the calendar-time monthly portfolio approach is susceptible to the bad
model problem. He argues that monthly portfolio returns have better statistical properties than
long-term holding-period returns.
In each year, we rank all firms into quintiles based on the net equity issuance (defined using
the method in Baker and Wurgler 2002) from July of the year t 1 to June of the year t.
21
We
form five portfolios and calculate equally weighted monthly returns for the period from July (t)
to June (t + 1). We form a hedge portfolio by selling Portfolio 1 (smallest offer size) and buying
Portfolio 5 (largest offer size), and calculate time-series average monthly returns. We find that
that Portfolio 5 underperforms Portfolio 1 by 0.22% per month (the t-statistic of the difference
equals 1.75). We then perform a similar analysis, but rank keiretsu firms and stand-alone firms
into quintiles separately. We find that, Portfolio 5 of the keiretsu firms underperforms Portfolio
1 by 0.31% per month (the t-statistic equals 2.21). In contrast, Portfolio 5 of the stand-alone
firms only underperforms Portfolio 1 by 0.17% per month and the difference is not statistically
significant (the t-statistic equals 1.36).
22
This result suggests that keiretsu firms are more likely
to time the market than stand-alone firms.
C. Use of the Proceeds from Equity Issuance
Our last two series of tests examines the use of the proceeds from external equity financing.
We first consider the effect of equity market timing on the different types of liability. If a firms
external financing decisions are mainly motivated by market timing considerations, then it is
likely that it will retain the cash or pay off some of its debt out of the proceeds, perhaps to free
up some capital at the main bank that can be redeployed within the group. To investigate this
possibility, we examine whether past market timing has a significantly negative impact on a firms
bank debt ratio.
20
Similar results are obtained if we replace the book-to-market-equity ratio by the market-to-book-assets ratio in the
regression.
21
For example, for a firm whose fiscal year-end is May, the net equity issuance measure covers the period from May
(t 1) to May (t), while for a firm whose fiscal year-end is December, the net equity issuance measure covers the period
from December (t 2) to December (t 1).
22
The average returns of five portfolios of keiretsu firms are 1.07%, 1.06%, 1.06%, 0.98%, and 0.76%, respectively, for
Portfolios 1 to 5. In contrast, the average returns of five portfolios of stand-alone firms are 1.01% (Portfolio 1), 1.05%,
1.02%, 0.94%, and 0.85% (Portfolio 5).
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Winter 2010
We estimate a regression that is similar to that in Equation (10), but use a different dependent
variable. In Equation (10), we consider the cumulative effect of the past issuance of capital (the
sum of debt and equity issues) on the overall leverage ratio. In this subsection, we examine the
cumulative effect of past equity market timing on the total bank-loans-to-assets ratio. We use
three main independent variables to measure equity market timing: 1) BWMB_E, 2) KTCOV_E,
and 3) BWFSE_E, which are collectively denoted as ETiming. They are obtained by replacing
total external financing (EF) with net equity issues (E) in Equations (1), (5), and (7). For
instance, KTCOV_E is the covariance between equity issue (E) and MB, scaled by the time-
series average of E. We also consider the interaction of these equity market timing measures
with K, our indicator variable for keiretsu membership. We control for the same vector X of the
control variables (MB, TANG, ROA, and SIZE) that we used in Equation (11)
LOAN/A
i,t
= a +
1
ETiming
i,t 1
+
2
K
i,t 1
+
3
ETiming K
i,t 1
+ yX
i,t 1
+ IND +
i,t
,
(14)
where LOAN/A is defined as bank loans divided by total assets. We expect a negative relationship
between LOAN/A and the equity market timing variables (ETiming) if firms use the proceeds from
equity issuances to repay their bank loans. More importantly for our purposes, we also expect
this negative association to be stronger for keiretsu firms than for stand-alone firms if keiretsu
firms are more likely to repay bank loans with the proceeds of equity offerings proceeds.
Past equity issues can be negatively related to the bank loan-to-assets ratio even if firms do not
use the proceeds of equity issuance to actively pay off their bank loans, but instead hoard the cash
or invest in new projects. In this case, the bank loan-to-assets ratio drops due to the increase in the
asset base, rather than a reduction in the amount of outstanding loans. To address this potential
concern, we estimate the following model.
(LOAN/OLIB)
i,t
= a +
1
ETiming
i,t 1
+
2
K
i,t 1
+
3
ETiming K
i,t 1
+ yX
i,t 1
+IND +
i,t
,
(15)
where LOAN/OLIB is defined as bank loans divided by other nonbank liabilities. This regression
focuses on the type, rather than the amount, of debt financing. We expect the effect of market
timing to be stronger on bank loans than on other liabilities. More importantly, we expect this
asymmetric effect to be stronger for keiretsu firms than for stand-alone firms.
Table VII reports the results from the regressions of another two measures of leverage ratio
on the market timing variables. We estimate the regressions in terms of level, which allows us
to consider the cumulative effects of market timing on the amount of bank loans on the balance
sheet. Columns (1) and (2) consider BWMB_E as a measure of equity market timing, Columns
(3) and (4) consider KTCOV_E, and Columns (5) and (6) consider BWFSE_E. We use LOAN/A
as the dependent variable in Columns (1), (3), and (5), and LOAN/OLIB in Columns (2), (4), and
(6).
The results confirm that bank loans are negatively related to all three measures of market
timing activity, irrespective of whether we scale the amount of bank loans by assets or by other
liabilities. In untabulated regressions, we omit K and its interactions with the three measures
of the timing variables to estimate the unconditional effect, and find it to be economically
significant. For example, an increase of one standard deviation in KTCOV_E leads to a reduction
of 8.7% in the average value of LOAN/A. More pertinently, the amount of bank loans is more
Chang et al.
r
Table VII. The Impact of Market Timing on Bank Loans
The dependent variable is 1) the bank-loans-to-total-assets ratio (LOAN/A) or 2) the bank-loans-to-total-
liabilities ratio (LOAN/OLIB). All control variables are as defined in Table I and are lagged one period
relative to the dependent variable. Industry dummies and the constant term are included in the regressions
but not reported. The model is estimated using Baker and Wurglers (2002) modified approach of the Fama
and MacBeth (1973) procedure, which is based on the number of years since firms enter PACAP.
ETiming = BWMB_E ETiming = KTCOV_E ETiming = BWFSE_E
(1) (2) (3) (4) (5) (6)
LOAN/A LOAN/OLIB LOAN/A LOAN/OLIB LOAN/A LOAN/OLIB
MB 0.023
0.052
0.015
0.067
0.021
0.148
(4.4) (2.3) (2.8) (3.1) (3.3) (4.4)

TANG 0.147
0.449
0.142
0.487
0.213
0.092
(14.4) (6.8) (13.4) (6.7) (37.9) (1.9)

ROA 1.302
5.642
1.300
5.456
0.896
3.507
(19.4) (15.3) (20.0) (15.8) (16.7) (9.7)

SIZE 0.008
0.157
0.007
0.147
0.006
0.144
(4.4) (15.9) (4.0) (15.8) (4.5) (22.4)

K 0.108
0.670
0.044
0.260
0.026
0.145
(28.2) (25.8) (26.3) (21.7) (10.5) (9.3)

ETiming 0.048
0.196
0.029
0.055
0.133
0.375
(9.5) (6.8) (9.2) (2.4) (6.4) (4.2)

K ETiming 0.041
0.276
0.024
0.207
0.089
0.667
(18.7) (17.8) (7.4) (6.4) (5.2) (6.5)

KTMB 0.060
0.445
(7.9) (9.1)
BWTSE_E 0.489
2.593
(5.8) (7.0)
BWLRV_E 0.598
3.058
(8.5) (10.1)
Constant 0.506
4.323
0.499
4.395
0.507
4.074
(16.5) (17.8) (15.2) (17.3) (14.0) (19.2)

Observations 36,916 36,657 37,057 36,796 37,057 36,796
R
2
0.25 0.18 0.24 0.16 0.13 0.07

negatively related to past market timing activity for keiretsu firms than for stand-alone firms.
In fact, the coefficients associated with the interactions between K and the three equity market
timing measures are significantly negative in all six columns (with t-statistics ranging from
5.2 to 18.7). The economic effect is also significant. For example, the sensitivity of keiretsu
members to KTCOV_E is approximately twice the sensitivity of stand-alone firms. In untabulated
regressions, we focus on keiretsu members and examine whether the degree of group affiliation
affects the market timing effect on bank loans. The results indicate that the effect is stronger for
closely affiliated members (I =1) than for loosely affiliated members (I =0). In the regressions
in which LOAN/A is the dependent variable, I BWMB_E, I KTCOV_E, and I BWFSE_E
are all negative, but only the first two variables are significant (with t-statistics equal to 7.1 and
r
Winter 2010
3.0), whereas I BWFSE_E is insignificant. The interaction terms are generally not significant
in the regression in which LOAN/OLIB is the dependent variable.
We also perform regression analysis to investigate the change in the alternative leverage ratios,
similar to the one reported in Table IV. In Table VIII, we estimate the regressions in terms of
changes over a five-year period, which allows us to directly examine how firms use the proceeds
from their equity issuances. We keep the same control variables as in Table VII, but we use
them to measure changes over a five-year period, rather than level. Columns (1) and (2) consider
BWMB_E as the measure of market timing, Columns (3) and (4) consider KTCOV_E, Columns
(5) and (6) consider BWFSE_E, and Columns (7) and (8) consider CSR. We use LOAN/A as the
dependent variable in Columns (1), (3), (5), and (7), and the ratio of LOAN/OLIB in the other
columns.
The results confirm our findings from the level specification in Table VII. Across all columns,
they indicate that firms that issue equity when equity prices are high reduce their bank leverage
(the t-statistics are significant in all of the columns except Column (4)). In addition, this effect is
stronger for keiretsu firms and the interaction between K and ETiming is significant in all of the
specifications except Column (4) (with t-statistics ranging from 1.0 to 5.6).
Our last series of tests consider the effect of market timing on the keiretsu members other than
the firm timing the capital market. To do so, we reestimate Model (10), but instead of using the
firm leverage as a dependent variable, we use the average bank-loans-to-assets ratio (average
Loan/A) for all the other firms that belong to the same keiretsu group. We only include keiretsu
firms in these regressions. We include conglomerate indicator variables to control for the potential
conglomerate fixed effects on average bank loan ratios and our usual firm control variables. If,
as we predict, keiretsu firms use the proceeds of their timed issuances to redeploy capital to other
members through loans, our different measures of market timing of a firm should be positively
associated with the average loan-to-assets ratio of other companies in the same group.
Table IX reports our results. The results are consistent with our expectations. They indicate
that our different measures of past market timing are all positively associated with the average
bank-loans-to-assets ratio of other firms in the group. We reach similar conclusions if we use the
average leverage ratio (Lev) instead of the average loan ratio (untabulated results). This finding is
also consistent with the notion that the proceeds of overvalued issuances are redeployed through
the group using bank loans as a vehicle.
V. Conclusion
The literature relying on US evidence has suggested the existence of two advantages in terms of
financing activities for the fully integrated conglomerates relative to focused stand-alone firms in
their financing. First, conglomerates may have better access to external capital markets (Dimitrov
and Tice, 2006). Second, conglomerates may substitute their internal capital markets for costly
external markets (Stein, 1997; Yan, 2006). We propose a third advantage for the conglomerate
structure. Japanese conglomerates offer a hybrid structure between fully integrated conglomerates
and stand-alone firms. This unusual structure implies that some members could be overpriced
while others could be underpriced at the same time. The keiretsu members can then cooperatively
time the market for the group as a whole by issuing equity for its overvalued members and
avoiding equity financing for its undervalued members. The proceeds from these overvalued
issuances of capital could then be redeployed throughout the group, for example, through loans
offered by the main bank of the group.
Chang et al.
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r
Winter 2010
Table IX. The Impact of Market Timing on Other Keiretsu Members
The dependent variable is the average bank loans-to-assets ratio (LOAN/A) for all the other firms that
belong to the same keiretsu group. BWMB_E is the external equity finance weighted average market-to-
book ratio of Baker and Wurgler (2002). KTCOV_E and KTMB_E are obtained according to Kayhan and
Titmans (2007) decomposition of BWMB_E. BWLRE_E, BWTSE_E, and BWFSE_E are the external equity
finance weighted average LRV, TSE, and FSE, respectively. LRV, TSE, and FSE are defined according to
Rhodes-Kropf, Robinson, and Viswanathan (2005). All control variables are as defined in Table I and are
lagged one period relative to the dependent variable. Industry dummies and the constant term are included
in the regressions but not reported. Keiretsu group dummies are included to capture the conglomerate fixed
effects. The model is estimated using Baker and Wurglers (2002) modified approach of the Fama and
MacBeth (1973) procedure, which is based on the number of years since firms enter PACAP.
Dependent Variable: Average LOAN/A of Other Keiretsu Members
(1) (2) (3)
ETiming = BWMB_E ETiming = KTCOV_E ETiming = BWFSE_E
MB 0.000 0.000
0.000
(1.4) (2.7) (1.3)
TANG 0.002
0.002
0.003
(14.7) (13.4) (16.1)

ROA 0.020
0.020
0.008
(25.2) (25.3) (9.4)

SIZE 0.000 0.000 0.000
(0.2) (0.7) (14.0)

ETiming 0.001
0.001
0.001
(8.4) (5.9) (1.7)

KTMB 0.002
(12.5)
BWTSE_E 0.012
(20.6)
BWLRV_E 0.008
(5.1)
Constant 0.257
0.256
0.258
(32.5) (32.6) (29.0)

Observations 14,396 14,396 14,391
R
2
0.14 0.14 0.11

We document a significant effect of market timing behavior on the capital structure of firms in
a general cross-section of publicly traded Japanese firms. Perhaps more importantly, we find that
the capital structure of firms that belong to keiretsu is more affected by past market conditions
than the capital structure of similar stand-alone firms. Keiretsu firms that have timed the issuance
of capital in the past have less debt in their capital structure. The differences are both economically
and statistically significant. In addition, the decision to issue equity is more closely correlated
with market conditions for firms that belong to keiretsu than for unaffiliated firms. We also
find that stock returns following the issuance of equity decrease with the size of the issuance, a
relationship that is more significant for firms that belong to keiretsu than for stand-alone firms.
Finally, we find that Japanese firms reduce the amount of bank loans outstanding after timing the
Chang et al.
r
equity market, and that this effect is materially stronger for keiretsu firms than for stand-alone
firms. In contrast, we find that keiretsu members other than those firms that have timed the
market when they have issued capital in the past, have more debt and bank loans in their capital
structure. Taken together, our results suggest that Japanese firms take advantage of the particular
setting offered by the keiretsu structure and the presence of financial institutions as shareholders
to engage in greater market timing activity and to redeploy the capital in the groups to other firms
that did not engage in market timing through bank loans.
Appendix: Denitions of the Variables
The financial variables used in this paper are defined as follows. All of the figures are represented in billions
of Japanese yen, and the parentheses indicate the corresponding data items in the PACAP database.
Variable Denition
Total assets (A) Book value of assets (BAL9).
Firm size (SIZE) Natural logarithm of net sales (INC1).
Profitability (ROA) Income from operations (INC5)/A.
Market-to-book
ratio (MB)
[Total assets (A) + Market capitalization Book equity (BAL21)]/A.
Book-to-market ratio
of equity (BTM)
Book equity (BAL21)/Market capitalization.
Asset tangibility
(TANG)
Net fixed assets (BAL7)/Total assets (A).
Financial institutional
ownership
(FinOwn)
Shares owned by business corporations (JAF76)/Total shares outstanding.
Business corporation
ownership
(BizOwn)
Shares owned by business corporations (JAF78)/Total shares outstanding.
Keiretsu
affiliation (K)
A dummy variable for keiretsu affiliation, as defined by various versions of
Industrial Grouping in Japan.
Book leverage
ratio (TDB)
Total liabilities (BAL17)/Total assets (A).
Deviation from
target leverage
ratio (DEVI)
Actual leverage ratio (TDB) Target debt ratio. Target leverage ratio is the
fitted value of the regression where TDB is regressed on the vector of
control variables (X) in Equation (10), together with year and industry
indicator variables.
Market leverage
ratio (Lev)
Total liabilities (BAL17)/[Total assets (A) + Market capitalization
(MKTCAP) Book equity (BAL21)].
Book-loans-to-assets
ratio (LOAN/A)
[Short-term loans payable (JAF33) + Current portion of long-term loans
payable (JAF34) + Long-term loans payable (JAF48)]/A.
Bank-loans-to-other-
liabilities ratio
(LOAN/OLIB)
Bank loans (JAF33 + JAF34 + JAF48)/Other liabilities (BAL17 JAF33
JAF34 JAF48).
Net debt issued (D) Change in total liabilities (BAL17).
Net equity
issued (E)
Change in book equity (BAL21) change in retained earnings (BAL20).
Issue A dummy variable that takes the value of one if E > 1% of total assets (A),
zero if D > 1% of A.
(Continued)
r
Winter 2010
Appendix: Denitions of the Variables (Continued)
Variable Denition
Total external
financing (EF)
Net debt issued (D) + Net equity issued (E).
Cumulative stock
returns (CSR)
The holding-period return over the 12 months before the end of the fiscal year.
Future holding-period
stock return (FSR)
The future 12-month holding-period return, starting from the end of the
current fiscal year.
Short-term debt Short-term loans payable (JAF33) + Current portion of long-term loans
payable (JAF34) + Current portion of bonds (JAF35).
Long-term debt Long-term loans payable (JAF48) + Bonds payable (JAF50) + Convertible
bonds payable (JAF51).
Debt maturity
(Maturity)
Short-term debt/[Short-term debt + Long-term debt].
Beta Computed as the coefficient of the market return in a regression in which the
weekly individual stock returns are regressed on the returns on the
value-weighted market index over a 52-week period.
Turnover The mean value of monthly shares traded (volume) divided by shares
outstanding over a 12-month period.
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Conglomerate Structure and Capital

Book leverage ratio (TDB) Mean 0.62 0.60 0.67

Median 0.65 0.61 0.70

Market leverage ratio (Lev) Mean 0.50 0.48 0.54

Median 0.50 0.48 0.54

Bank loans-to-total liabilities (LOAN/A) Mean 0.22 0.20 0.25

Median 0.18 0.15 0.22

Bank loans-to-other liabilities (LOAN/OLIB) Mean 12.5 12.5 12.5

Firm size (SIZE) Mean 11.0 10.8 11.3

Median 10.9 10.8 11.2

Profitability (ROA) Mean 0.042 0.044 0.038

Median 0.038 0.040 0.035

Market-to-book ratio (MB) Mean 1.42 1.44 1.39

Median 1.23 1.23 1.24

Median 0.24 0.24 0.24

Median 31.0% 29.1% 35.0%

Business corporation ownership (BusOwn) Mean 30.1% 30.0% 30.4%

Median 26.1% 26.1% 26.1%

Number of firm years 40,136 26,387 13,749

Significant at the 0.01 level.

Significant at the 0.05 level.

(18.0) (18.8) (20.0)

(1.8) (1.8) (9.7)

(23.2) (23.8) (9.4)

(4.4) (3.9) (6.8)

(12.0) (10.5) (6.1)

(8.9) (8.2) (14.0)

(9.9) (3.1) (8.2)

(19.9) (19.2) (21.7)

Significant at the 0.01 level.

Significant at the 0.10 level.

(6.2) (9.1) (10.8)

(18.8) (23.9) (23.3)

(26.4) (25.1) (16.8)

(8.4) (14.0) (19.4)

(0.9) (3.3) (2.0)

(17.9) (8.9) (6.8)

(3.9) (3.4) (3.2)

(1.5) (2.5) (4.0)

Significant at the 0.01 level.

Significant at the 0.05 level.

Significant at the 0.10 level.

Significant at the 0.01 level.

Significant at the 0.05 level.

(13.9) (14.6) (13.4) (1.8) (2.1) (2.1)

(18.0) (19.3) (16.2) (3.9) (3.6) (3.7)

0.013 0.045 0.073

(5.5) (6.1) (5.0) (2.6) (3.9) (4.5)

(8.2) (9.1) (7.2) (2.5) (2.7) (2.6)

(9.1) (8.8) (9.5) (2.4) (2.5) (2.6)

(9.2) (7.6) (11.7) (2.6) (2.0) (2.2)

0.010 0.022 0.033

(3.8) (4.0) (5.3) (1.6) (1.6) (1.9)

0.278 0.225 0.389

(2.9) (2.3) (2.8) (0.8) (1.7) (2.3)

(16.3) (14.6) (11.8) (2.3) (2.6) (2.4)

Significant at the 0.01 level.

Significant at the 0.05 level.

Significant at the 0.10 level.

(4.4) (2.3) (2.8) (3.1) (3.3) (4.4)

(14.4) (6.8) (13.4) (6.7) (37.9) (1.9)

(19.4) (15.3) (20.0) (15.8) (16.7) (9.7)

(4.4) (15.9) (4.0) (15.8) (4.5) (22.4)

(28.2) (25.8) (26.3) (21.7) (10.5) (9.3)