What Drives Security Issuance Decisions : Market Timing, Pecking Order, or Both?

We study the interaction between market timing and pecking order in the financing decision of firms. Using a sample of debt and equity issues and share repurchases of Canadian firms during 1998-2007, we find that only when firms are not financially constrained, they are more likely to issue (repurchase) equity when their shares are overvalued (undervalued), and post-announcement long-run returns are lower for overvalued firms. These findings are more consistent with the market timing theory than rational financing theories. We also find support for the pecking order theory which predicts that firms prefer debt to equity financing unless they are financially constrained, but this result only holds for firms that are not overvalued. These findings highlight an interaction between the effects of market timing and pecking order: firms time the market in issuing or repurchasing equity only when they are not financially constrained, and pecking order is most likely to hold among undervalued firms