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Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

The notion that firms have a debt ratio target which is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the evidence? We address this issue by generating samples where financing is unrelated to a firm’s current debt ratio or a target. We find that much of the available evidence in favor of target behavior based on leverage ratio changes can be reproduced for these samples. Taken together, our findings suggest that a number of existing tests of target behavior have no power to reject alternatives.

A number of prominent papers in the literature have estimated the speed of adjustment (SOA) of firms ’ leverage ratios with estimators not designed for applications in which the dependent variable is a ratio. This made them detect mean reversion, which they mistakenly considered as readjustment. We propose a non-parametric way to model leverage ratios under the NULL, and a method of reconciling incongruous estimates. Using the earlier estimators, the best joint estimate for the true SOA is zero or negative. There is evidence for some heterogeneity in SOAs across firms.

We find that equity mispricing impacts the speed at which firms adjust to their target leverage and does so in predictable ways depending on whether the firm is over- or underlevered. For example, firms that are above their target leverage and should therefore issue equity (or retire debt), adjust more rapidly to their target when their equity is overvalued. However, when a firm is undervalued, but needs to reduce leverage, the speed of adjustment is much slower. Our findings support the role of equity mispricing as an important factor that alters the cost of making adjustments within the dynamic trade-off theory.

Recent survey evidence suggests that managers try to time financial markets in making their financing decisions. We examine a sample of more than 14,000 new issues of corporate debt to test for evidence of timing of new debt issues. We focus our attention on interest rates in terms of their decile rankings relative to historical rates, and we identify differences in the characteristics of debt issued in light of the decile levels. We find evidence of interest rate timing in that the number of debt issues and the amounts of debt issued are higher when interest rates are in low deciles. Debt maturity choices, call features, and put features are affected by the decile ranking of interest rates. Bond ratings tend to be lower when interest rates are in higher deciles, and the fraction of speculative grade issues also increases. Cross-sectional evidence shows that firms with greater financial flexibility have a greater tendency to time. We also examine the effects of refinancing transactions, and we find that timing is present whether debt is issued for the purpose of refinancing existing debt or as an increment to outstanding debt. Finally, we test for whether the average debt issue would have been more costly had the decision to issue been postponed.

We test the market timing theory of capital structure using UK data by estimating intrinsic value of equities and find that the effect is statistically and economically significant. Managers increase debt (equity) issues during periods of undervaluation (overvaluation). We show that repurchasing behavior is equally influenced by equity mispricing. Financial constraints do affect timing behavior: Constrained firms are more sensitive to equity mispricing and the effect is evident particularly in repurchasing activities. Managers, thus, seem to time issues strategically out of necessity rather than being able to do so. Both timing of issues and repurchasing are influenced by reaching target leverage. The evidence suggests that managers are clearly aware of the cost of being off-target and weigh this against benefit gained from timing the market.

Abstract: We survey the theory and evidence of behavioral corporate finance, which generally takes one of two approaches. The market timing and catering approach views managerial financing and investment decisions as rational managerial responses to securities mispricing. The managerial biases approach studies the direct effects of managers ’ biases and nonstandard preferences on their decisions. We review relevant psychology, economic theory and predictions, empirical challenges, empirical evidence, new directions such as behavioral signaling, and open questions.