ARTICLE IN PRESS

Journal of Financial Economics 76 (2005) 549–582

0304-405X/$

doi:10.1016/j

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Richard Sans

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Financing decisions: who issues stock?$

Eugene F. Famaa, Kenneth R. Frenchb,�

aGraduate School of Business, University of Chicago, Chicago, IL 60637, USAbAmos Tuck School of Business, Dartmouth College, Hanover, NH 03755, USA

Available online 30 December 2004

Abstract

Financing decisions seem to violate the central predictions of the pecking order model about

how often and under what circumstances firms issue equity. Specifically, most firms issue or

retire equity each year, and the issues are on average large and not typically done by firms

under duress. We estimate that during 1973–2002, the year-by-year equity decisions of more

than half of our sample firms violate the pecking order.

r 2004 Elsevier B.V. All rights reserved.

JEL classification: G132

Keywords: Financing decisions; Pecking order; Asymmetric information; Equity issues; Repurchases

1. Introduction

The modern corporate finance literature focuses on two competing models toexplain the financing decisions of firms. In the tradeoff model, firms identify optimalleverage by weighing the costs and benefits of an additional dollar of debt. Thebenefits of debt include, for example, the tax deductibility of interest and the

- see front matter r 2004 Elsevier B.V. All rights reserved.

.jfineco.2004.10.003

owledge the helpful comments of Elroy Dimson, Michael Katz, Stewart Myers, Richard Roll,

ing Rene Stulz, workshop participants at Dartmouth, the University of Chicago, Yale, and

nd especially Clyde Stickney and two anonymous referees. We thank Michael McWilliams

y Savina Rizova for excellent research assistance.

nding author.

dress: kfrench@dartmouth.edu (K.R. French).

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E.F. Fama, K.R. French / Journal of Financial Economics 76 (2005) 549–582550

reduction of free-cash-flow agency problems. The costs of debt include potentialbankruptcy costs and agency conflicts between stockholders and bondholders. At theleverage optimum, the benefit of the last dollar of debt just offsets the cost.

Myers (1984) advocates an alternative theory, the pecking order model. Thepecking order arises if the costs of issuing risky securities—transactions costs andespecially the costs created by management’s superior information about the value ofthe firm’s risky securities—overwhelm the costs and benefits proposed by thetradeoff model. The costs of issuing risky securities spawn the pecking order: firmsfinance new investments first with retained earnings, then with safe debt, then riskydebt, and finally, but only under duress, with outside equity.

The pecking order sequence for financing decisions leads to a prediction aboutcapital structures. Specifically, variation in a firm’s leverage is driven not by thetradeoff model’s costs and benefits of debt or equity, but more simply, by the firm’sfinancing deficit (dividends plus investment outlays minus earnings). Quoting Myers(1984), ‘‘The crucial difference between this and the static tradeoff story is that, inthe modified pecking order story, observed debt ratios will reflect the cumulativerequirement for external financing—a requirement cumulated over an extendedperiod’’.

In short, Myers (1984) presents the pecking order model as a theory both abouthow firms finance themselves and about the capital structures that result frompecking order financing. Subsequent tests of the model follow these two routes. Forexample, Shyam-Sunder and Myers (1999), Fama and French (2002), and Frank andGoyal (2003) test the model’s predictions about the securities firms issue to coverfinancing deficits, while Titman and Wessels (1988), Rajan and Zingales (1995),Shyam-Sunder and Myers (1999), Fama and French (2002), and Huang and Song(2003) test the model’s predictions about capital structures.

This earlier work mainly uses cross-section regressions to test the pecking ordermodel. Cross-section regressions measure average responses of financing decisionsand capital structures to variables such as growth and profitability (the ingredients ofthe financing deficit). But average responses may conceal important details relevantfor judging the model. We take a more direct approach. We test pecking orderpredictions about financing decisions by examining how often and under whatcircumstances firms issue and repurchase equity. We uncover what seem to bepervasive contradictions of the model.

The first important result is striking evidence against the pecking order predictionthat firms rarely issue stock. As motivation for the pecking order, Myers (1984)emphasizes that aggregate net new issues of equity are small relative to net new debt.It is also well-known that seasoned equity offerings (SEOs) are rare. But theaggregate level of equity financing and the scarcity of SEOs are misleading. Inaddition to SEOs, firms issue equity in mergers and through private placements,convertible debt, warrants, direct purchase plans, rights issues, and employeeoptions, grants, and benefit plans. During 1973 to 1982, on average 67% of oursample firms issue some equity each year, and the proportion rises to 74% for 1983to 1992 and 86% for 1993 to 2002. During much of the sample period, however,repurchases by some firms offset the equity issues of others, and aggregate annual

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net new equity is small. This result, along with the low frequency of SEOs, leads tothe misleading impression that new issues of stock are rare.

In fact, most firms issue, repurchase, or do both every year. And our examinationof the firms that issue or retire equity shows that equity decisions often violate thepecking order. Thus, equity issuers are not typically under duress; net issues arecommon among firms with moderate leverage and financing surpluses (earningsexceed the sum of dividends and investment). Also in violation of the pecking order,repurchases are not limited to firms with low demand for outside financing; manyfirms with financing deficits repurchase stock. We estimate that during 1973 to 2002,the year-by-year equity decisions of more than half of our sample firms contradictthe pecking order.

Moreover, annual net issues of equity are material. For example, on average61.5% of small firms (total assets below the NYSE median) make net issuesof stock each year from 1983 to 1992, and the average rises to 73.7% for 1993 to2002. These annual net stock issues average 6.0% of assets during 1983 to 1992 and12.6% for 1993 to 2002, both larger than the annual net new debt of these firms,which averages 5.2% and 6.4% of assets for the two periods. On average 66.5% ofbig firms make net stock issues each year of the 1993 to 2002 period, and their netequity issues are about the same magnitude, 7.5% of assets, as their net issues ofdebt, 7.9%.

The fact that equity issues and repurchases are commonplace and commonly notin line with the pecking order seems like a telling blow to the argument of Myers(1984) and Myers and Majluf (1984) that asymmetric information problems drive thecapital structures of firms. Myers (1984) and Myers and Majluf (1984) do not allowfor equity issues that do not have an asymmetric information problem. One story forour results is that there are important ways to issue equity that avoid this problem. Ifso, the pecking order, as the stand-alone model of capital structure proposed byMyers (1984), is dead: financing with equity is not a last resort, and asymmetricinformation problems are not the sole (or perhaps even an important) determinant ofcapital structures. This does not mean the asymmetric information problemdisappears. But its implications become quite limited: firms do not follow thepecking order in financing decisions; they simply avoid issuing equity in ways thatinvolve asymmetric information problems.

Our measure of equity issues is all encompassing, including any transaction thatincreases the number of (split-adjusted) shares outstanding. This leads some readersto argue that our results say nothing about the pecking order because we includestock issues that do not have asymmetric information problems. But again, thepecking order is proposed by Myers (1984) and Myers and Majluf (1984) as acomplete model of capital structures, so our broad measure of equity issues isrelevant for analyzing its predictions about how capital structures are determined.For example, issues of stock to employees via options and grants play a big role inour results on the frequency of equity issues. Stock issues to employees may not havean asymmetric information problem. A firm nevertheless alters its capital structurewhen it compensates employees with stock instead of cash—and chooses not tooffset the stock issues with repurchases. In short, if the pecking order model can only

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handle ways of issuing equity that involve large asymmetric information problems, itis not a model of capital structure.

The breakdown of the pecking order does not require that equity can be issuedwith minor asymmetric information problems. Anything that produces the resultthat equity is not a last resort will do. For example, agency problems may sometimeslead managers to ignore the costs of issuing equity (Jung et al., 1996). It is also likelythat some equity issues have benefits that outweigh their costs, i.e., tradeoff effects.For example, getting stock in a merger can have tax benefits for shareholders of theacquired firm that lead them to accept a lower price for their shares. Similarly, stockissued to employees may have motivation benefits that outweigh any asymmetricinformation costs. The important point is that any forces that cause firms to deviatesystematically from pecking order financing (retained earnings, then debt, and equityonly as a last resort) imply that the pecking order model, on its own, cannot explaincapital structures.

Our story proceeds as follows. Section 2 outlines the pecking order model. Section3 documents how the profitability and growth characteristics of firms, which areimportant for understanding financing decisions, change through time. Our mainempirical results are in Sections 4–6. The theme of these sections is that violations ofthe pecking order become more evident when financing decisions are examined atmore disaggregated levels. Section 4 examines financing decisions at the level of themarket, where we find little evidence against the pecking order model, except later inthe sample period. Section 5, the paper’s centerpiece, disaggregates firms into 12groups formed on size, profitability, and growth, and examines in detail how equityissuers in the 12 groups differ from repurchasers. Here we find widespread evidenceof pecking order violations. Section 6 provides evidence on the mechanisms firms useto issue equity. The concluding section discusses the implications of our findings.

2. The pecking order model

Myers (1984) uses Myers and Majluf (1984) to motivate the pecking order. InMyers and Majluf (1984), managers use private information to issue risky securitieswhen they are overpriced. Investors are aware of this asymmetric informationproblem, and the prices of risky securities fall when new issues are announced.Managers anticipate the price declines, and may forego profitable investments if theymust be financed with risky securities. To avoid this distortion of investmentdecisions, managers follow what Myers (1984) calls the pecking order. They financeprojects first with retained earnings, which have no asymmetric informationproblem, then with low-risk debt, for which the problem is negligible, then withrisky debt. Equity is issued only under duress, or when investment so far exceedsearnings that financing with debt would produce excessive leverage. Myers (1984)also posits that in the short term, dividends are (for unspecified reasons) sticky,leaving variation in net cashflows to be absorbed mainly by debt.

Myers (1984) largely ignores share repurchases. Shyam-Sunder and Myers (1999)address the issue, and argue that the asymmetric information problem of new

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common stock applies to repurchases. If a firm announces a repurchase, investorsassume managers have positive information not reflected in the stock price, causingthe price to rise. This can deter the repurchase if the price rises above what managersconsider the equilibrium level. More important, debt capacity is a valuable optionfor future financing. Thus, when firms use financing surpluses to retire securities,they first retire debt. They retire equity only when leverage is low or when poorinvestment opportunities (relative to earnings) lower the value of debt capacity. Inshort, repurchases should be limited to firms with little or no leverage, fewinvestment opportunities, or both.

Two additional points about the pecking order are pertinent for interpreting ourempirical results. First, Myers (1984) emphasizes asymmetric information problems,but he recognizes that transactions costs alone can produce pecking order financingif they are higher for debt than for retained earnings and higher yet for equity. Inother words, asymmetric information may be unnecessary.

Second, in Myers (1984) and Myers and Majluf (1984), the pecking orderarises through an implicit assumption that there is no way to issue equity thatavoids asymmetric information problems. If firms find ways to issue equitywithout such problems, asymmetric information may not constrain equity issues.As a result, pecking order financing can disappear; that is, financing withequity is not a last resort, the incentive to avoid repurchases to maintain debtcapacity is gone, and asymmetric information problems do not drive capitalstructures. This does not mean asymmetric information is irrelevant. But itsimplications become quite limited. Firms do avoid issuing risky securities in waysthat involve asymmetric information problems, but financing decisions do not followthe pecking order.

The capital structure literature focuses on SEOs as the source of outside equity.There are at least seven other ways firms issue equity: (1) mergers via an exchange ofstock, (2) employee stock options, grants, and other employee benefit plans, (3)subscription rights issued to stockholders, (4) warrants attached to other securities,(5) convertible bonds, (6) dividend reinvestment and other direct purchase plans, and(7) private placements. Do some of the mechanisms for issuing equity involve lowtransactions costs and minor asymmetric information problems?

Consider transactions costs. SEOs, warrants, and convertible bonds have largeunderwriting costs. The large price concessions in private placements of equity(Wruck, 1989; Hertzel et al., 2002) are also a high transaction cost. In contrast, rightsofferings are not costly (Smith, 1977). Issuing stock to employees via grants, options,and other benefit plans also probably involves low transactions costs. The same istrue for direct purchase plans. Negotiating mergers is costly, but the marginal cost ofcarrying out an exchange of stock may not be high. In short, four of the alternativesfor issuing stock seem to involve low transactions costs.

Asymmetric information is a stickier issue. Myers (1984) posits that stock pricedeclines in response to announcements of equity issues reflect asymmetricinformation problems. If so, the problems are severe for SEOs (Masulis andKorwar, 1986), and present but weaker for convertible bonds (Mikkelson andPartch, 1986). Wruck (1989) and Hertzel et al. (2002) find that the stock price

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response to private placements is positive. Though their samples are small, Smith(1977) and Eckbo and Masulis (1992) find no evidence of a reliable negative priceresponse to announcements of rights issues. The price responses to initiations ofdividend reinvestment plans (Peterson et al., 1987; Allen et al., 1995) and ESOPplans (Chaplinsky and Niehaus, 1994) also seem to be small. Moeller et al. (2004)find that the negative price responses to stock-financed mergers are limited toacquisitions of publicly traded firms by big publicly traded firms. Otherwise, mergersfinanced with stock do not seem to have negative price effects.

Stock issues in direct purchase plans are initiated by the purchasers (mostlyexisting stockholders), not by managers, so asymmetric information problems maybe absent. Asymmetric information problems may be minor in stock-financedmergers because mergers are negotiated between informed parties. Likewise,asymmetric information may not be important in grants of stock and options toemployees because employees are informed or the issues are a matter of routine. Andstock issues in mergers and to employees are important in our later evidence on thefrequency and magnitude of issues.

But asymmetric information problems can never be ruled out. Firms can alwaysuse repurchases to offset stock issues to employees, in mergers, and in directpurchase plans. The decision not to repurchase may be interpreted as evidence thatmanagers think the stock is overvalued—an asymmetric information problem. Asalways, the information conveyed by any action depends on the market’sexpectations. Unfortunately, event studies cannot settle the matter unambiguouslysince price responses to announcements may not be due solely to asymmetricinformation problems.

We are not arguing that asymmetric information problems are unavoidable.Indeed, it is likely that the asymmetric information problems that arise with someways of issuing stock (most notably SEOs) do not lead to pecking order financing(equity is not a last resort and asymmetric information problems do not drive capitalstructures) because firms can issue equity in other ways that largely avoidasymmetric information problems. The discussion above suggests that the primecandidates for breaking the grip of the pecking order are stock issues to employees,with perhaps a minor assist from rights offerings and direct purchase plans, and a bigassist from stock-financed mergers.

Breaking the grip of the pecking order does not require that equity can be issuedwith minor asymmetric information problems and low transactions costs. Any forcesthat produce the result that equity is not a last resort will do. One possibility is thatagency problems sometimes lead managers to ignore equity issuing costs (Jung et al.,1996). A potentially important alternative is that equity issues can have benefits thatoutweigh their costs, i.e., tradeoff effects. For example, an exchange of stock in amerger can create a tax benefit that offsets asymmetric information costs. By payingwith stock, the acquiring firm allows target shareholders to postpone capital gainstaxes, which should lead the shareholders to accept a lower price for their shares.Similarly, the motivation benefits of stock issued to employees may outweighasymmetric information costs if there are any. The important point is that any forcesthat cause firms to deviate systematically from pecking order financing (retained

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earnings, then debt, and equity only as a last resort) imply that the pecking ordermodel cannot alone explain capital structures.

Finally, in developing the pecking order model, Myers (1984) takes dividenddecisions as given and outside the purview of the model. This is a patch on themodel, a tacit admission that tradeoff forces or other factors are important individend decisions since the asymmetric information story in itself would predict thatdividends (like repurchases) are rare. There is a second important patch. Theconcluding sections of Myers (1984) and Myers and Majluf (1984) argue that firmswant to avoid debt that may result in distress that prevents them from exercisingfuture investment options. As a result, firms with large current and expectedinvestments relative to earnings may issue equity even though leverage is moderate.This patch on the pecking order model allows firms with large current and expectedfinancing deficits to opt out of simple pecking order behavior, causing such firms tolook more like those predicted by the tradeoff model (they incur current asymmetricinformation costs because of expected future benefits).

In evaluating the empirical results that follow, we largely let the pecking orderretain these two patches, to give the model its best shot at explaining the evidence.

3. The characteristics of sample firms

The profitability and growth characteristics of firms are central in evaluating theirfinancing decisions. Thus, we begin the empirical work with a brief description of thechanging characteristics of listed firms. The data are from CRSP and Compustat, theperiod is 1973 to 2002 (when Compustat’s coverage of listed firms is fairly complete),and the sample includes NYSE, AMEX, and Nasdaq firms. We exclude financialfirms and utilities. Financial intermediaries do not seem relevant for testing modelsof financing decisions, and during much of the sample period, regulation isimportant in the capital structure decisions of utilities.

The number of listed non-financial, non-utility firms with the necessary data forlater tests rises from an average of 2,951 for 1973 to 1982, to 4,417 for 1993 to 2002(Table 1). The increase is primarily among small firms, defined as NYSE, AMEX,and Nasdaq firms with total assets below the NYSE median. The number of bigfirms only rises from an average of 617 for 1973 to 1982, to 712 for 1993 to 2002.

To illustrate the changing characteristics of firms, Table 1 separately allocatessmall and big firms to portfolios formed as the intersections of three profitability andtwo growth groups. The breakpoints for the profitability and growth groups areaverages of NYSE annual medians for 1973 to 2002. The three profitability groupsfor each year include firms with (i) negative earnings before interest (E), (ii) lowprofitability (earnings relative to total assets, E/A, below the average median forNYSE firms with positive E), and (iii) high profitability (E/A above the averageNYSE median). The two growth groups include firms with (i) low asset growth foryear t (dA/A=(At�At�1)/At below the average median for NYSE firms) and (ii) highasset growth (dA/A above the NYSE average median). The appendix containsprecise definitions of E/A, dA/A, and our other variables.

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Table 1

Average number of firms in size-profitability-growth groups

Each year’s sample of all firms includes all non-financial (SIC codes between 6000 and 6999), non-utility (4900–4949) firms with the necessary CRSP and

Compustat data for that year (see the appendix). Firms are assigned to the Small and Big portfolios and to the 12 size-profitability-growth portfolios in year t

based on their characteristics at the end of their fiscal year in calendar year t. The assets of small and big firms in year t are below or above those of the median

NYSE firm in t. The breakpoints for growth and positive profitability are the averages of the annual NYSE medians for 1973 to 2002. A firm is assigned to the

low- or high-growth group for year t if its growth in assets, dA/A=(At�At�1)/At, is below or above the average median for 1973 to 2002. A profitable firm is

assigned to the low- or high-profitability group for t if its earnings relative to assets, E/A, is below or above the 1973 to 2002 average median of NYSE firms

with positive profitability.

All

firms

Small Big Small Big

E/A: Negative E Low E/A High E/A Negative E Low E/A High E/A

dA/A: Low High Low High Low High Low High Low High Low High

1973–1982 2951 2334 617 186 47 459 412 340 887 11 2 130 154 71 246

1983–1992 3672 3126 545 757 224 579 518 329 717 38 8 144 109 93 152

1993–2002 4417 3704 712 1018 398 606 676 298 707 54 33 191 185 104 142

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556

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There are fairly general increases in the number of big firms in differentprofitability and growth groups. The group of big firms with high profitability andhigh growth is the only one that shrinks, from an average of 246 for 1973 to 1982, to142 for 1993 to 2002. Thus, the population of profitable, rapidly growing big firmscontracts through time, but all other big groups expand.

The number of small firms (mostly on Nasdaq) explodes during the sample period,but the increases are not uniform across groups. The notable surges are for smallunprofitable firms and small firms with positive but low profitability. The number ofsmall highly profitable firms actually declines, from an average of 1,227 for 1973 to1982, to 1,005 for 1993 to 2002.

In short, the number of listed firms increases from 1973 to 2002, largely due to aninflux of unprofitable and low-profitability firms. The number of highly profitablefirms actually declines. These patterns are common to both small and big firms, butfor groups with increasing numbers of firms, the increases among small firms dwarfthose for big firms.

Lemmon and Zender (2002) argue that equity issues by fast-growing firms withlow profitability are rational opt-outs allowed by the pecking order (via the patchdiscussed above). They argue that the increased frequency of such firms, obvious inTable 1, explains the apparent evidence against the pecking order of Frank andGoyal (2003). When we later examine equity issuers and repurchasers in the 12 size-profitability-growth groups in detail, however, we find that violations of the peckingorder are pervasive. The violations are not limited to fast-growing low-profitabilityfirms.

4. The market

Table 2 summarizes the aggregate financing decisions of all sample firms,the market. The variables in Table 2 (and in later tables) are ratios, and thedenominator is total assets. Specifically, the variables are book leverage (totalliabilities over total assets, L/A), the market-to-book ratio for total assets(V/A, a proxy for Tobin’s Q), profitability (E/A), asset growth (dA/A), net debtissues (dL/A), the change in balance sheet retained earnings (dRE/A), and twomeasures of net equity issues (dSB/A and dSM/A). The ratios are calculated as theaggregate value of the numerator divided by aggregate assets, which in effect treatsthe entire sample as a single firm. Equivalently, the ratios are size-weighted averagesof the ratios for firms, where a firm’s ratio is weighted by its assets relative toaggregate assets. Finally, the ratios are multiplied by 100, and thus are expressed aspercents of assets.

Our results center on pecking order predictions about which firms issue equity. Weshow two measures of annual equity issues. The first, dSB, is the change in the bookvalue of stockholders’ equity in excess of the change in Compustat’s adjusted balancesheet retained earnings,

dSB ¼ dSE � dRE: (1)

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Table 2

Average characteristics of all firms

Each year’s sample includes all non-financial, non-utility firms with the necessary CRSP and Compustat

data for that year (see the appendix). We report the average ratio of the annual aggregate value of the

numerator for a portfolio divided by the aggregate value of assets, in percent. Thus, leverage, L/A(t), is the

sum of total liabilities in year t (Compustat item 181) divided by the sum of assets in year t (6); L/A(t�1) is

L/A for the previous fiscal year, t�1; dL/A is the aggregate change in liabilities from t�1 to t divided by

the sum of assets at t; dA/A is the aggregate growth in assets from t�1 to t divided by the sum of year t

assets; profitability, E/A, is the aggregate of the sum of income before extraordinary items (18), interest

expense (15), and extraordinary income (48) if available, divided by aggregate assets; dRE/A is the sum of

the change in Compustat’s adjusted retained earnings (36) from t�1 to t divided by aggregate assets at t;

the financing deficit, Def/A, is the difference between the growth in assets and the change in retained

earnings, dA/A�dRE/A; the book measure of net equity issued, dSB/A, is the financing deficit minus the

change in liabilities, Def/A�dL/A; and the market-based measure of net stock issued, dSM, is the split-

adjusted change in Compustat shares outstanding (25) during the fiscal year times the average of the

beginning and ending split-adjusted Compustat stock prices (199). The market-to-book ratio for total

assets, V/A, is the aggregate of the sum of book value of debt and the market value of equity divided by

aggregate assets.

Firms dSM/A dSB/A dL/A dRE/A dA/A V/A L/A E/A Def/A

t t�1

1973–1982 2951 0.8 0.7 6.5 3.0 10.3 110.5 57.5 56.9 7.7 7.2

1983–1992 3672 0.5 0.3 6.6 1.1 8.0 132.4 64.4 62.8 6.5 6.9

1993–2002 4417 4.0 2.4 6.2 0.5 9.1 186.2 68.0 68.0 5.0 8.6

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The change in stockholders’ equity, dSE, combines (i) issues and repurchases ofequity, (ii) the change in retained earnings, and (iii) ‘‘dirty surplus’’ transactions suchas foreign currency translation adjustments. Since dirty surplus transactions do notflow through the income statement, they do not affect a firm’s reported value ofretained earnings. These transactions are typically incorporated, however, inCompustat’s adjusted value of retained earnings (data item 36), so we use thismeasure to compute dSB.

Both pooling of interests mergers and employee stock options cause dSB tounderstate stock issues. In a pooling of interests merger, stockholders’ equityincreases by the book value of the acquired firm’s stock, not by the (typically greater)market value of the shares issued to the acquired firm’s shareholders. When stockoptions are exercised, stockholders’ equity rises by the strike price plus the taxessaved because of the exercise, not by the (typically greater) market value of theshares issued.1 Stock dividends also contaminate dSB. When a firm pays a stock

1The tax effect arises because of differences between the way options are expensed for tax and financial

reporting purposes. During our sample period, few firms recognize the cost of executive options in their

financial statements. When an option is exercised, however, the difference between the market value of the

stock and the strike price is an expense for tax purposes. This expense reduces the firm’s tax liability and

drives a permanent wedge between the tax expense reported in the financial statements and the actual taxes

paid. The tax savings are credited to stockholders’ equity without flowing through the income statement.

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dividend, it transfers the market value of the shares issued from its retained earningsaccount to its contributed capital account. As a result, dSB misclassifies stockdividends as new equity issued.

Our second measure of equity issued during a fiscal year, dSM, is the (split-adjusted) change in the number of shares outstanding over the fiscal year times theaverage of the (split-adjusted) stock prices at the beginning and end of the fiscal year.(See the appendix for details.) Since the market-based dSM does not suffer from theaccounting problems of dSB, it is a more accurate measure of equity financing, andthus is the central variable in the tests below. But we also show dSB because itbalances financing sources and investment,

dL=A þ dSB=A þ dRE=A ¼ dA=A (2)

and it produces the financing deficit in Table 2,

Def=A ¼ dA=A � dRE=A ¼ dL=A þ dSB=A: (3)

Both dSB/A and dSM/A are superior to another measure of outsideequity financing, net cash from stock issued—the difference between inflows fromnew issues and outflows for repurchases, from the statement of cash flows. Thismeasure, used by Frank and Goyal (2003) and Lemmon and Zender (2002),understates equity issued because the statement of cash flows does not show stockissued in mergers or outright grants of stock to employees because such issuesproduce no cash flows. The change in Treasury stock used by Fama and French(2001) has similar problems.

The aggregate profitability and growth of sample firms change through time.Profitability, E/A, falls from an average of 7.7% for 1973 to 1982, to 5.0%for 1993 to 2002 (Table 2). Earnings in excess of dividends (dRE/A) alsofall, averaging 3.0% of assets for 1973 to 1982 and 0.5% for 1993 to 2002.Asset growth declines, but less, from 10.3% per year to 9.1%. Since asset growthdeclines less than the change in retained earnings, outside financing increases. Theincrease is not met with new debt, which falls a bit; dL/A averages 6.5% per year for1973 to 1982, and 6.2% for 1993 to 2002. New issues of equity fill the void. During1973 to 1982 and 1983 to 1992, annual aggregate net new equity averages 0.8% and0.5% of assets, and most outside financing is debt. Myers (1984) uses the relativelylow level of aggregate equity financing to motivate the pecking order. ConfirmingFrank and Goyal (2003), however, during 1993 to 2002 equity financing isimportant, even at the aggregate level; annual net new equity, dSM/A, averages asubstantial 4.0% of assets, which is about two-thirds as large as net new debt (6.2%per year).

Aggregate results are, however, largely irrelevant for judging the predictions of thepecking order. The pecking order is a model of financing decisions by individualfirms. Because aggregate results hide much variation in the financing of individualfirms, aggregate results can be misleading. When we next examine financing decisionsat a more disaggregated level, we find lots of behavior inconsistent with the peckingorder—throughout the 1973 to 2002 period.

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5. Who issues stock?

In the pecking order model, transactions costs and asymmetric informationproblems lead firms to finance first with internal funds and then with debt. Equity isissued only under duress or when investment so far exceeds earnings that financingwith debt would produce excessive leverage. Since pecking order predictions aboutwhen firms issue equity are the lynchpin of the model, this section examines theevidence in detail.

5.1. Incidence and materiality of equity issues

The pecking order model predicts that few firms issue or repurchase shares. Infact, most firms issue, repurchase, or do both every year. Table 3 shows averageannual percents of sample firms with net repurchases (dSMo0), net issues(dSM40), or neither (dSM=0)—mutually exclusive categories. The table alsoshows percents of firms with gross issues and gross repurchases. These groups arenot mutually exclusive; a firm can be in one, both, or neither of the groups. Inaddition to results for all sample firms, Table 3 shows separate results for small andbig firms.

Raising immediate suspicions about the extent to which financing decisions followthe pecking order (equity as a last resort), the average fraction of sample firms withno net equity issues (dSM=0) falls from a rather low 24% per year for 1973 to 1982,to 8% per year for 1993 to 2002. Big firms almost always make annual net issues ornet repurchases. The fraction of big firms with no net issues is 11% per year for 1973to 1982 and 2% for 1993 to 2002. Despite the literature’s emphasis on repurchases,the fraction of all sample firms with net repurchases hovers around a modest 20%per year. During the last 20 years of the sample (1983 to 2002), a more impressive30% per year of big firms make net repurchases.

Most firms make annual net issues of equity. The average annual fraction ofsample firms with net issues (dSM40) rises from more than half (54% per year) for1973 to 1982, to 62% for 1983 to 1992, and an impressive 72% for 1993 to 2002. Theincrease in net issuers among all sample firms is driven by small firms. The fraction ofbig firms with net issues of equity is always high, averaging 72%, 66%, and 67% peryear for the three ten-year periods of Table 3.

The pecking order model is silent on why firms pay dividends, but issuing stock topay dividends seems like a problem. Specifically, if asymmetric information meansstock must be issued at below equilibrium value, issuing stock to pay dividendsdecreases the wealth of current shareholders. In contrast, reducing dividends doesnot cause permanent wealth losses for long-term shareholders even if asymmetricinformation problems cause the stock price to fall temporarily below its equilibriumvalue.

Dividend payers are more likely to repurchase than non-payers, especially during1983 to 2002. For example, though not shown in Table 3, during 1993 to 2002, onaverage 37% of each year’s dividend payers make net repurchases, versus 15% fornon-payers. And firms that do not pay dividends are more likely to issue equity than

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Table 3

Average percents of firms that issue and repurchase equity and average issues and repurchases as percents

of total assets

Each year’s sample (All) includes all non-financial, non-utility firms with the necessary CRSP and

Compustat data for that year (see the appendix). Firms are assigned to the Small or Big category in year t

if their assets are below or above those of the median NYSE firm in t. The market-based measure of net

stock issued, dSM, is the split-adjusted change in Compustat shares outstanding during the fiscal year

times the average of the beginning and ending split-adjusted Compustat stock prices. Thus, net stock

issuers have a positive split-adjusted growth in shares, dSM40, and net stock repurchasers have a negative

growth in shares, dSMo0. Gross stock repurchases, GR, is Compustat annual item 115. Gross stock

issues, GI, is net issues, dSM, plus gross repurchases.

% in dSM group % with GI40 % with GR40 % with GI/A41%

All Small Big All Small Big All Small Big All Small Big

Part A: percent of firms in dSM categories that issue and repurchase

All dSM groups

1973–1982 100 100 100 67 63 83 30 29 32 24 23 25

1983–1992 100 100 100 74 71 89 33 29 52 40 40 37

1993–2002 100 100 100 86 84 91 42 39 59 57 58 51

dSMo0

1973–1982 21 22 18 56 55 60 83 83 86 11 10 12

1983–1992 20 18 29 56 50 75 88 86 93 18 15 28

1993–2002 20 18 31 64 59 78 92 90 96 26 23 34

dSM=0

1973–1982 24 28 11 6 6 8 6 6 8 1 1 1

1983–1992 18 20 4 4 3 10 4 3 10 1 1 2

1993–2002 8 9 2 6 5 24 6 5 24 2 1 8

dSM40

1973–1982 54 50 72 100 100 100 19 18 23 38 41 32

1983–1992 62 61 66 100 100 100 23 21 37 58 61 43

1993–2002 72 74 67 100 100 100 33 31 43 71 73 61

dSM/A GI/A GR/A

All Small Big All Small Big All Small Big

Part B: issues and repurchases as percents of assets

All dSM groups

1973–1982 0.8 1.2 0.8 1.1 1.7 1.0 0.3 0.5 0.2

1983–1992 0.5 3.3 0.2 1.7 4.2 1.5 1.2 1.0 1.3

1993–2002 4.0 7.9 3.5 5.6 9.4 5.2 1.7 1.4 1.7

dSMo0

1973–1982 �0.9 �1.7 �0.8 0.2 0.1 0.2 1.1 1.8 1.0

1983–1992 �2.3 �3.4 �2.2 0.6 0.1 0.6 2.9 3.5 2.9

1993–2002 �2.6 �4.7 �2.5 0.9 0.4 0.9 3.5 5.1 3.4

dSM=0

1973–1982 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.1 0.0

1983–1992 0.0 0.0 0.0 0.1 0.0 0.1 0.1 0.0 0.1

1993–2002 0.0 0.0 0.0 0.6 0.1 0.8 0.6 0.1 0.8

dSM40

1973–1982 1.4 2.7 1.3 1.5 2.8 1.4 0.1 0.1 0.1

1983–1992 2.3 6.1 1.9 2.6 6.3 2.2 0.3 0.3 0.3

1993–2002 8.2 12.6 7.5 8.8 13.0 8.2 0.6 0.4 0.7

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dividend payers. Nevertheless, in apparent contradiction of the pecking order,during 1973 to 2002 on average about 58% of each year’s dividend payers make netissues of equity.

The fractions of firms with net equity issues or net repurchases each year are high,but they understate the frequency of issues and repurchases. Many firms that are netissuers in a given year repurchase in the same year, and most firms that make netrepurchases also issue. On average, 19% of the firms that make net issues of equityduring 1973 to 1982 repurchase in the same year, and the average rises to 33% for1993 to 2002 (Table 3). As a result, the fraction of all sample firms making grossrepurchases (30% per year, rising to 42%) is much higher than the fraction makingnet repurchases. More impressive, of each year’s sample of firms with netrepurchases (dSMo0), 56% issue equity in the same year during 1973 to 1982and the fraction rises to 64% during 1993 to 2002 (Table 3). As a result, most samplefirms (67% per year for 1973 to 1982 and 86% for 1993 to 2002) issue some equityeach year.2 Big firms are especially active. The fractions with gross issues of equity,gross repurchases, and both issues and repurchases are higher for big firms than forsmall firms (Table 3).

Some equity issues are tiny, so it is interesting to examine the frequency of issuesabove a non-trivial threshold, say 1% of assets. The fraction of all sample firms withgross issues that exceed 1% of assets rises from 24% per year for 1973 to 1982, to40% for 1983 to 1992, and 57% for 1993 to 2002 (Table 3). More impressive, amongthe high fractions of firms that make net issues of equity, in a typical year 38% of the1973 to 1982 sample make equity issues that exceed 1% of assets, and the fractionrises to 58% for 1983 to 1992 and 71% for 1993 to 2002.

A caveat is in order. We see later that for individual firms, the equity issuingprocess is lumpy, with smaller issues during most years but large issues during someyears, the result of relatively infrequent SEOs and mergers. The distribution ofequity issues is thus skewed right, and tabulating annual percents of firms that makeissues above some threshold (1% of assets) gives a misleadingly low impression ofthe cumulative effects of issues. A better picture of cumulative effects is obtained(next) by comparing average annual equity issues with average debt issues.

Consider the firms that are net issuers of equity in a given year, dSM40. Theirannual net equity issues average 1.4% of assets during 1973 to 1982, 2.3% for 1983to 1992, and an impressive 8.2% for 1993 to 2002 (Part B of Table 3). Their grossissues are larger, averaging 1.5%, 2.6%, and 8.8% of assets. The annual net new debtof these firms averages about 7.0% of assets (Table 4). Thus, for firms that make netissues of equity, the issues are substantial relative to new issues of debt, especiallyduring the last 20 years of the sample period. For the seven of ten sample firms that

2Note that Compustat reports zero gross repurchases for some firms making net repurchases (dSMo0).

Compustat’s gross repurchases are from the Statement of Cashflows. A cashless repurchase can occur in a

variety of ways. For example, a shareholder (typically an employee) can deliver shares as payment on a

loan from the company, the firm can exchange other property for outstanding shares, or an employee can

forfeit non-vested shares when leaving the firm. Some cases, however, are probably Compustat errors

(reporting zero cash repurchases when they are in fact positive).

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make annual net equity issues during 1993 to 2002, aggregate net new equity exceedsnet new debt.

The aggregate issues of all net issuers quoted above are dominated by big firms, soit is interesting to examine small firms. The net equity issues of small firms that arenet issuers tend to be even more substantial, averaging 2.7% of assets for 1973 to1982, 6.1% for 1983 to 1992, and 12.6% for 1993 to 2002 (Table 3). In contrast, thenet new debt for these firms averages about 6.0% of assets, and net new debt is lessthan net new equity during both 1983 to 1992 and 1993 to 2002 (Table 4).

In short, during the last 20 years of the sample, on average about two-thirds ofeach year’s firms make net equity issues. For big firms that are net issuers, net newissues of equity are on average about one-third the size of net new debt during 1983to 1992, and they are about as large as new debt during 1993 to 2002 (Table 4). Forsmall firms that make net equity issues, the issues are on average larger than net newdebt for the entire 1983 to 2002 period. And it is worth adding that the evidence forsmall firms cannot be dismissed as unimportant for judging the pecking order modelsince the asymmetric information problems that generate its predictions aboutfinancing decisions are probably more serious for smaller firms.

Though net issuers outnumber repurchasers about three to one, firms that retireequity tend to be larger. As a result, for the sample as a whole, aggregate net newequity averages just 0.8% of assets for the first ten years of the sample (1973 to 1982)and 0.5% for 1983 to 1992 (Table 3). These aggregates are clearly misleading,however. They are not due to the paucity of equity issues predicted by the peckingorder. On the contrary, they are the result of equity issues by a large fraction of firmsthat are offset by repurchases by others. During 1993 to 2002, even aggregate netnew equity is no longer small, averaging 4.0% of the assets of sample firms and 8.2%of the assets of net issuers (as compared to about 6.2% for net new debt).

5.2. The characteristics of firms that make net issues or repurchases

Since the pecking order model leads us to expect that equity issues and repurchasesare rare, the fact that almost all firms do one or the other—or both—every yearsuggests that many firms violate the model’s predictions about equity decisions. Thekey variables in the predictions are profitability and growth, the main ingredients ofthe financing deficit. Thus, to examine the extent to which equity decisions conformto the model, we break the sample into groups of firms with similar profitability andgrowth. Specifically, as in Table 1, we allocate firms to 12 groups each year based onsize (big and small), profitability (negative, low, and high E/A), and growth (low andhigh dA/A). Table 4 summarizes the characteristics of the net equity issuers and netrepurchasers in the overall sample, for small and big firms separately, and for each ofthe 12 size-profitability-growth groups.

The market-to-book ratios, V/A, in Table 4 are normalized. Fama and French(2001) find that the upward drift in market V/A after 1980, apparent in Table 2, isnot matched by drift in aggregate profitability or growth. Based on this evidence,they conclude that the drift in V/A reflects a decline in expected returns (discountrates) rather than better investment opportunities that might affect financing

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Table 4

Average characteristics of firms that make net repurchases (dSMo0) or net issues (dSM40)

Each year’s sample (All firms) includes all non-financial, non-utility firms with the necessary CRSP and Compustat data for that year (see the appendix). Firms

are assigned to the 12 size-profitability-growth groups in year t based on their characteristics at the end of their fiscal year in calendar year t. The assets of small

and big firms in year t are below or above those of the median NYSE firm in t. The breakpoints for growth (dA/A) and positive profitability (E/A) are the

averages of the annual NYSE medians for 1973 to 2002. We report the average ratio of the annual aggregate value of the numerator for a group divided by the

aggregate value of assets, in percent. Thus leverage, L/A(t), is the sum of total liabilities in year t divided by the sum of assets in year t; L/A(t�1) is L/A for the

previous fiscal year, t�1; dL/A is the aggregate change in liabilities from t�1 to t divided by the sum of assets at t; dA/A is the aggregate growth in assets from

t�1 to t divided by the sum of year t assets; profitability, E/A, is the aggregate sum of income before extraordinary items, interest expense, and extraordinary

income if available, divided by aggregate assets; dRE/A is the sum of the change in Compustat’s adjusted retained earnings from t�1 to t divided by aggregate

assets at t; the financing deficit, Def/A, is the difference between the growth in assets and the change in retained earnings, dA/A�dRE/A; the book measure of

net equity issued, dSB/A, is the financing deficit minus the change in liabilities, Def/A�dL/A; and the market-based measure of net stock issued, dSM, is the

split-adjusted change in Compustat shares outstanding during the fiscal year times the average of the beginning and ending split-adjusted Compustat stock

prices. The % of Group is the average of the annual percents of All firms and of firms in the 12 size-profitability-growth groups with dSMo0 (Net repurchases)

and dSM40 (Net issues). The market-to-book ratio for total assets, V/A, is the aggregate of the sum of book value of debt and the market value of equity

divided by aggregate assets. We standardize V/A by dividing each year’s V/A for a group by V/A for all firms.

Firms % of

Group

dSM/A dSB/A dL/A dRE/A dA/A V/A L/A E/A Def/A

t t�1

Part A: average characteristics of all sample firms

All firms: dSMo0

1973–1982 622 21.3 �0.9 �0.4 5.6 3.1 8.3 95.2 55.1 54.0 8.3 5.2

1983–1992 737 20.0 �2.3 �1.6 8.1 1.8 8.3 103.0 63.1 60.1 7.6 6.5

1993–2002 873 19.7 �2.6 �1.8 4.0 2.0 4.2 103.1 69.0 67.8 7.3 2.2

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All firms: dSM40

1973–1982 1608 54.3 1.4 1.1 6.9 3.2 11.2 103.2 57.3 56.7 7.8 8.0

1983–1992 2284 62.3 2.3 1.5 5.7 0.7 7.9 100.3 64.9 64.2 6.1 7.2

1993–2002 3202 72.5 8.2 5.1 7.7 �0.3 12.5 99.4 67.3 68.0 3.7 12.8

Small firms: dSMo0

1973–1982 514 22.3 �1.7 �0.6 4.4 3.1 6.9 91.3 50.5 49.5 8.5 3.8

1983–1992 578 18.4 �3.4 �1.7 3.9 1.2 3.4 107.5 52.1 49.9 6.7 2.2

1993–2002 647 17.5 �4.7 �2.8 2.9 1.5 1.7 90.8 51.0 49.0 6.0 0.2

Small firms: dSM40

1973–1982 1165 49.6 2.7 2.0 6.8 4.2 13.0 114.5 52.3 52.4 8.9 8.8

1983–1992 1920 61.5 6.0 4.5 5.2 0.9 10.7 123.4 54.4 55.0 5.4 9.8

1993–2002 2730 73.7 12.6 8.7 6.4 �2.9 12.2 112.5 52.3 52.4 0.3 15.1

Big firms: dSMo0

1973–1982 108 17.6 �0.8 �0.3 5.8 3.1 8.6 96.0 55.7 54.6 8.3 5.5

1983–1992 158 29.3 �2.2 �1.6 8.3 1.9 8.6 102.7 63.8 60.8 7.7 6.7

1993–2002 226 31.4 �2.5 �1.8 4.1 2.0 4.4 104.1 70.3 69.2 7.4 2.3

Big firms: dSM40

1973–1982 443 71.8 1.3 1.0 6.9 3.1 11.0 102.2 57.7 57.1 7.7 7.9

1983–1992 364 66.6 1.9 1.1 5.8 0.6 7.5 97.4 66.3 65.4 6.2 6.9

1993–2002 471 66.5 7.5 4.5 7.9 0.1 12.5 97.6 69.4 70.2 4.2 12.4

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Part B: average characteristics of high-growth firms

Small, unprofitable, high-growth firms: dSMo0

1973–1982 4 13.5 �1.1 �0.5 28.5 �10.2 17.9 143.8 72.9 53.8 �5.8 28.1

1983–1992 11 5.1 �5.6 1.9 31.0 �9.8 23.1 93.6 63.7 44.1 �5.9 32.9

1993–2002 12 3.2 �10.6 2.3 29.3 �9.0 22.6 87.2 63.2 43.9 �5.4 31.6

Small, unprofitable, high-growth firms: dSM40

1973–1982 31 57.4 12.5 8.1 25.0 �10.7 22.3 149.4 68.9 56.6 �6.9 33.0

1983–1992 189 84.1 25.0 19.7 22.6 �13.6 28.7 153.3 57.7 49.3 �10.6 42.3

1993–2002 371 93.1 38.2 32.1 23.0 �18.3 36.8 134.8 50.7 43.9 �15.6 55.1

Big, unprofitable, high-growth firms: dSMo0

1973–1982 0 7.3 �0.2 0.4 10.8 �2.5 8.7 93.8 63.6 57.8 �1.1 11.2

1983–1992 0 6.3 �0.6 �0.5 30.9 �8.1 22.3 88.2 79.6 61.4 �2.0 30.4

1993–2002 2 5.6 �2.2 0.8 25.5 �9.9 16.4 89.4 71.3 55.0 �5.9 26.3

Big, unprofitable, high-growth firms: dSM40

1973–1982 1 70.8 0.3 0.9 19.3 �7.5 12.6 82.4 71.2 59.7 �4.0 20.2

1983–1992 7 89.8 6.5 9.0 24.2 �10.5 22.7 93.1 78.2 70.5 �6.0 33.2

1993–2002 31 93.7 28.0 26.2 25.8 �8.0 44.0 92.2 64.2 67.7 �5.5 52.0

Small, low-profitability, high-growth firms: dSMo0

1973–1982 88 21.1 �0.8 �0.1 13.9 1.9 15.8 79.7 59.1 53.6 6.0 13.8

1983–1992 79 15.3 �2.0 �0.5 16.5 1.8 17.8 89.1 61.2 54.4 5.6 16.0

1993–2002 87 13.1 �2.7 �1.5 16.4 2.3 17.2 73.0 58.5 50.8 5.6 15.0

Table 4 (Continued)

Firms % of

Group

dSM/A dSB/A dL/A dRE/A dA/A V/A L/A E/A Def/A

t t�1

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Small, low-profitability, high-growth firms: dSM40

1973–1982 209 51.4 2.5 2.3 14.9 2.3 19.4 94.8 59.7 55.7 6.2 17.2

1983–1992 355 68.7 7.1 5.9 16.9 2.5 25.3 104.8 56.4 52.9 5.6 22.8

1993–2002 538 79.9 13.3 9.1 16.0 2.9 28.0 101.4 52.5 50.7 5.1 25.1

Big, low-profitability, high-growth firms: dSMo0

1973–1982 25 15.4 �0.7 �0.4 14.1 1.6 15.2 85.4 71.4 67.9 5.0 13.6

1983–1992 24 21.4 �1.3 �0.8 18.6 1.1 18.8 84.2 75.9 70.3 4.7 17.8

1993–2002 35 18.7 �1.0 �0.5 13.7 1.5 14.8 76.0 82.0 80.0 4.5 13.2

Big, low-profitability, high-growth firms: dSM40

1973–1982 111 73.6 1.2 1.2 11.1 1.7 14.0 87.6 66.3 64.2 5.7 12.3

1983–1992 81 75.1 2.1 1.9 16.8 1.2 20.0 85.6 71.4 67.9 5.4 18.8

1993–2002 147 79.9 8.4 5.2 16.9 1.6 23.7 82.8 73.4 73.7 4.5 22.1

Small, high-profitability, high-growth firms: dSMo0

1973–1982 166 19.1 �1.5 �0.3 8.9 6.6 15.2 107.1 46.4 44.2 12.1 8.6

1983–1992 121 16.7 �4.0 �1.3 9.9 7.1 15.6 146.5 46.3 43.2 12.7 8.5

1993–2002 114 16.8 �4.8 �2.8 9.0 9.5 15.7 128.6 46.0 43.9 13.8 6.2

Small, high-profitability, high-growth firms: dSM40

1973–1982 558 61.8 3.6 2.6 10.0 7.3 19.9 137.5 47.5 46.9 11.9 12.6

1983–1992 509 71.6 7.1 4.7 8.8 8.3 21.8 165.6 45.0 46.3 12.2 13.5

1993–2002 555 78.2 12.1 6.1 7.6 10.4 24.1 163.8 41.1 44.1 12.7 13.7

Big, high-profitability, high-growth firms: dSMo0

1973–1982 38 15.6 �0.8 �0.3 7.4 5.3 12.3 110.9 48.6 47.0 11.3 7.1

1983–1992 45 29.7 �2.5 �1.7 10.0 5.3 13.6 143.8 54.3 51.3 11.9 8.3

1993–2002 45 31.6 �3.3 �1.7 8.8 6.2 13.3 167.2 58.4 57.2 13.4 7.2

Big, high-profitability, high-growth firms: dSM40

1973–1982 194 78.6 2.0 1.3 7.7 5.6 14.6 129.7 48.9 48.2 10.8 9.0

1983–1992 101 66.6 3.6 1.8 9.4 5.9 17.2 139.1 54.1 54.0 11.1 11.3

1993–2002 94 66.5 11.9 4.0 9.2 8.1 21.3 180.5 52.5 54.9 12.2 13.2

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Part C: average characteristics of low-growth firms

Small, unprofitable, low-growth firms: dSMo0

1973–1982 28 16.3 �1.3 �0.6 �6.2 �13.9 �20.7 80.8 60.8 55.5 �9.1 �6.8

1983–1992 104 13.7 �2.9 �1.8 �2.2 �15.6 �19.6 84.6 59.9 52.0 �11.2 �4.0

1993–2002 126 12.0 �3.7 �2.1 �5.3 �18.1 �25.4 68.7 55.0 48.2 �15.2 �7.3

Small, unprofitable, low-growth firms: dSM40

1973–1982 73 36.3 2.5 2.2 �11.1 �15.2 �24.1 98.4 71.1 65.4 �9.4 �8.9

1983–1992 431 57.1 4.8 3.6 �5.7 �20.3 �22.5 102.1 66.3 58.7 �15.5 �2.1

1993–2002 776 76.1 10.5 7.6 �3.5 �29.0 �25.0 92.9 59.9 51.0 �25.0 4.0

Big, unprofitable, low-growth firms: dSMo0

1973–1982 1 9.3 �0.4 �0.3 �6.8 �10.3 �17.3 82.0 76.0 69.9 �6.6 �7.0

1983–1992 6 16.1 �3.7 �2.7 0.9 �16.1 �18.0 93.1 71.5 59.5 �10.3 �1.8

1993–2002 10 21.0 �3.4 �2.4 0.5 �13.9 �15.8 78.0 70.1 60.1 �8.0 �1.9

Big, unprofitable, low-growth firms: dSM40

1973–1982 7 61.2 0.3 0.7 2.0 �9.1 �6.4 74.1 68.7 62.6 �4.8 2.7

1983–1992 29 77.8 0.9 1.0 �0.5 �11.9 �11.3 81.3 73.8 66.8 �7.1 0.6

1993–2002 42 76.7 3.3 2.7 �1.2 �18.4 �16.9 90.5 74.4 64.8 �12.5 1.5

Small, low-profitability, low-growth firms: dSMo0

1973–1982 127 27.4 �1.2 �0.7 �2.1 0.6 �2.1 73.8 52.4 53.3 5.3 �2.8

1983–1992 163 28.2 �2.5 �1.8 �2.0 0.2 �3.5 81.7 51.6 51.8 5.1 �3.8

1993–2002 178 29.4 �3.1 �2.2 �1.4 1.2 �2.4 67.8 50.4 50.6 5.0 �3.6

Small, low-profitability, low-growth firms: dSM40

1973–1982 152 34.1 0.8 0.6 �2.9 0.8 �1.5 81.5 55.9 58.0 5.6 �2.3

1983–1992 265 45.8 1.7 1.4 �3.8 �0.2 �2.6 87.0 56.3 58.6 4.9 �2.4

1993–2002 341 56.3 2.1 1.3 �4.4 0.5 �2.6 68.6 58.2 61.0 4.7 �3.1

Table 4 (Continued)

Firms % of

Group

dSM/A dSB/A dL/A dRE/A dA/A V/A L/A E/A Def/A

t t�1 E.F

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Big, low-profitability, low-growth firms: dSMo0

1973–1982 26 19.7 �0.7 �0.3 �0.6 1.2 0.3 77.9 57.6 58.2 5.7 �0.9

1983–1992 40 29.8 �1.6 �1.4 1.6 0.3 0.6 85.1 63.3 62.1 6.1 0.3

1993–2002 68 36.1 �1.8 �1.7 �1.2 0.4 �2.5 78.5 70.4 69.7 5.1 �2.9

Big, low-profitability, low-growth firms: dSM40

1973–1982 79 61.3 0.4 0.4 1.2 1.1 2.6 81.0 61.4 61.8 5.2 1.6

1983–1992 96 65.0 1.0 �0.7 �3.7 �1.5 �5.9 85.8 66.9 67.1 5.4 �4.4

1993–2002 117 60.7 1.1 0.5 �1.4 0.2 �0.6 73.6 72.8 73.7 4.6 �0.8

Small, high-profitability, low-growth firms: dSMo0

1973–1982 98 29.7 �3.7 �1.3 �3.5 4.1 �0.8 98.2 44.4 47.5 11.4 �4.9

1983–1992 97 29.5 �5.3 �3.3 �4.1 3.8 �3.6 124.1 47.4 49.7 12.1 �7.5

1993–2002 127 42.2 �8.7 �5.2 �3.7 5.8 �3.1 111.5 49.4 51.5 12.7 �8.9

Small, high-profitability, low-growth firms: dSM40

1973–1982 141 40.6 1.3 0.7 �6.0 5.1 �0.1 99.7 49.5 55.5 11.1 �5.3

1983–1992 169 51.4 3.1 2.2 �10.2 4.2 �3.8 113.7 59.4 66.9 12.1 �8.1

1993–2002 146 49.6 4.1 1.9 �12.5 7.0 �3.6 100.9 61.6 71.6 13.6 �10.6

Big, high-profitability, low-growth firms: dSMo0

1973–1982 16 25.0 �1.6 �0.8 �0.7 3.8 2.3 100.8 49.4 51.2 10.3 �1.5

1983–1992 42 44.7 �4.5 �2.8 0.1 2.3 �0.3 119.5 58.6 58.3 10.9 �2.7

1993–2002 63 60.5 �4.6 �3.5 �2.2 3.8 �2.0 133.9 64.0 64.8 11.7 �5.8

Big, high-profitability, low-growth firms: dSM40

1973–1982 49 66.1 1.3 0.4 �1.3 3.9 3.0 97.2 51.1 54.0 9.9 �1.0

1983–1992 48 51.8 1.6 0.7 �3.6 2.9 0.0 110.7 64.1 67.6 10.5 �3.0

1993–2002 39 37.7 2.4 0.3 �9.7 2.6 �6.8 116.3 66.9 71.4 10.6 �9.4

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decisions. Thus, to better isolate the information in V/A about the investmentopportunities of our 12 groups, we normalize by dividing the values of V/A for year t

by market V/A for t.The pecking order model predicts that equity issuers are highly levered and

repurchasers have little debt. But Part A of Table 4 shows that when we aggregateacross all sample firms, net issuers and net repurchasers have similar leverage at thebeginning of the year (before the year’s financing decisions). Equity issuers do differfrom repurchasers in other respects. Issuers as a whole are less profitable and growfaster, especially during 1993 to 2002. And lower profitability and faster growth leadequity issuers to issue more debt (dL/A is higher). As a result, net issuers andrepurchasers have similar leverage after as well as before the financing decisions ofyear t (which might be viewed as a hint of tradeoff behavior).

The fact that in aggregate net equity issuers are less profitable and grow fasterthan firms that repurchase seems to support Lemmon and Zender (2002). They arguethat though equity issuers may have moderate leverage, they face larger current andexpected financing deficits, which put them among the rational opt-outs allowed bythe (patched version of the) pecking order. Advocates of the pecking order modelshould, however, be uncomfortable with the argument that this version allows largefractions of our sample firms (54% for 1973 to 1982, rising to 72% for 1993 to 2002)to opt out of the pecking order and make annual net equity issues. But there is noneed to quarrel. Closer examination of our 12 size-profitability-growth groups showsthat large fractions of firms of all types make equity decisions that seem inconsistentwith the pecking order.

Consider fast-growing firms, which consistently have large financing deficits. Thefact that most unprofitable fast-growing firms make net equity issues each year (PartB of Table 4) can be viewed as consistent with at least the patched version of thepecking order. If they did not issue equity, the leverage of these firms would quicklybe far above average. One might draw the same inference about the more than 73%of big rapidly-growing firms with positive but low profitability that make net equityissues each year, since these firms have relatively high leverage.

Annual net equity issues by more than half (more than two-thirds during 1983 to2002) of small, low-profitability, fast-growing firms are, however, a problem for thepecking order. The issuing firms in this group start the year with low leverage, andleverage would be moderate even if no equity were issued. Likewise, on average morethan 61% of each year’s highly profitable fast-growing firms issue equity (Part B ofTable 4). This is a clear problem for the pecking order since the leverage of issuerswould be low even if they issued no equity.

Equity issues by some groups of fast-growing firms may be consistent with thepecking order, but repurchases are a contradiction. Fast-growing firms in all size-profitability groups have large financing deficits and they issue lots of debt. Thus,they have a clear demand for debt capacity, and issuing debt to retire equity is aproblem for the pecking order. Few unprofitable fast-growing firms retire equity, butnet repurchases are more common among profitable high-growth firms. On averageabout 14% of small fast-growing firms with low profitability and about 17% withhigh profitability make annual net repurchases during 1983 to 2002. The numbers for

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big fast-growing firms are higher. About 20% of those with low profitability andabout 30% of the highly profitable make annual net repurchases during 1983 to2002.

Part C of Table 4 shows the characteristics of low-growth firms that issue or retireequity each year. Without showing the details, we can report that, examined at amore aggregate level (that is, if one does not separately examine net issuers andrepurchasers), low-growth firms do not seem to present serious problems for thepecking order model. For example, in aggregate, low-growth firms with positiveprofitability do not issue or retire much equity, and they typically have financingsurpluses which they use to retire debt, all of which is consistent with the peckingorder.

Once again, however, aggregates are misleading. Part C of Table 4 shows thatmost low-growth firms issue or retire equity each year. Among low-growth firmswith positive profitability, 20% to 61% make net repurchases each year and 34–66%make net issues. Repurchases by profitable low-growth firms may be consistent withthe pecking order since these firms tend to have financing surpluses, moderateleverage, and so apparently little need for more debt capacity. But net equity issuesby large fractions of these firms are a pecking order problem; profitable low-growthfirms with financing surpluses and moderate leverage should not issue equity to retireadditional debt. Finally, the equity issues of large fractions of unprofitable low-growth firms are consistent with the pecking order since these firms are under duress(they are quite unprofitable and are rapidly disgorging assets). But then the fact that9–21% of such firms make net repurchases seems like a pecking order problem.

Table 5 summarizes the evidence from Table 4 about how well the pecking orderexplains equity issues and repurchases. Net issues and repurchases by firms in the 12size-profitability-growth groups are counted as consistent (Y) or inconsistent (N)with the model based on its predictions about equity (discussed above) for firms ineach group. Firms that are neither net issuers nor repurchasers are taken to beconsistent with the pecking order. The last two columns of the table show theaverage percents of total sample firms that can be counted for or against the model.

Despite the decline through time in the incidence of firms that neither issue norrepurchase equity and the increase in the incidence of firms that make net issues, theaverage percent of firms whose equity decisions are consistent with the pecking orderrises from 41% for 1973 to 1982, to 49% for 1993 to 2002. The improvedperformance of the pecking order is largely due to the increasing numbers of smallunprofitable firms whose net equity issues are taken to be consistent with the model.But the important point is that even during 1993 to 2002, more than half of the netissues and repurchases of sample firms run counter to the model. In short, thepecking order does a poor job describing the equity decisions of individual firms.

Without showing the details, we can also report that bigger firms are more likelyto violate the pecking order. The firms whose equity decisions obey the pecking orderaccount for 25%, 32%, and 43% of the market capitalization of sample firms duringthe three ten-year periods of 1973 to 2002, leaving 75%, 68%, and 57% as modelfailures. These results are surprising, given the evidence in Frank and Goyal (2003)and Lemmon and Zender (2002) that the pecking order works better for bigger firms.

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Average percents of total firms that are consistent with the predictions of the pecking order model

After splitting each size-profitability-growth group into firms making net repurchases (dSMo0), issues (dSM40), or neither (dSM=0), we categorize their

financing decisions as consistent (Y) or inconsistent (N) with the pecking order model based on the evidence in Table 4. The Percent of all firms shows the

fraction of the sample firms in each size-profitability-growth group. The blocks for dSMo0, dSM=0, and dSM40 show the fraction of the sample firms whose

behavior is consistent or inconsistent with the pecking order model. The Total percent for these blocks aggregates the other columns in the block and shows the

fraction of all sample firms that are net repurchasers, issuers, or neither, and are consistent or inconsistent with the pecking order. The Total percent for all firms

aggregates the Total percent results for dSMo0, dSM=0, and dSM40, and thus shows the fraction of all sample firms whose behavior is consistent or

inconsistent with the pecking order model.

Market Small Big Total percent

E/A: Negative E Low E/A High E/A Negative E Low E/A High E/A Y N

dA/A: Low High Low High Low High Low High Low High Low High

Percent of all firms

1973–1982 100.0 6.1 1.6 15.5 14.2 11.4 30.2 0.4 0.1 4.4 5.4 2.4 8.4 40.9 59.0

1983–1992 100.0 20.6 6.1 15.8 14.1 9.0 19.6 1.0 0.2 3.9 3.0 2.5 4.1 46.9 52.8

1993–2002 100.0 23.3 8.9 13.9 15.1 6.7 15.8 1.3 0.8 4.4 4.2 2.4 3.2 48.8 51.2

dSMo0

Pecking order behavior? N N Y N Y N N N N Y N Y N

1973–1982 21.3 1.0 0.2 4.3 3.1 3.3 5.7 0.0 0.0 0.9 0.9 0.5 1.3 9.0 12.2

1983–1992 20.0 2.8 0.3 4.4 2.2 2.6 3.3 0.2 0.0 1.1 0.7 1.1 1.2 9.2 10.7

1993–2002 19.7 2.9 0.3 4.1 2.0 2.9 2.6 0.3 0.0 1.6 0.8 1.4 1.0 10.0 9.9

dSM=0

Pecking order behavior? Y Y Y Y Y Y Y Y Y Y Y Y Y N

1973–1982 24.4 2.8 0.4 6.1 4.0 3.4 5.6 0.1 0.0 0.9 0.6 0.2 0.5 24.4 0.0

1983–1992 17.7 6.0 0.6 4.1 2.3 1.7 2.4 0.1 0.0 0.2 0.1 0.1 0.2 17.7 0.0

1993–2002 7.7 2.6 0.3 2.0 1.1 0.5 0.8 0.0 0.0 0.1 0.1 0.0 0.1 7.7 0.0

dSM40

Pecking order behavior? Y Y N N N N Y Y N Y N N Y N

1973–1982 54.3 2.4 1.0 5.1 7.2 4.7 18.9 0.2 0.0 2.7 3.9 1.6 6.6 7.5 46.8

1983–1992 62.3 11.7 5.1 7.2 9.7 4.6 13.9 0.8 0.2 2.6 2.2 1.3 2.8 20.0 42.1

1993–2002 72.5 17.8 8.3 7.8 12.1 3.3 12.4 1.0 0.7 2.7 3.3 0.9 2.1 31.1 41.3

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The earlier papers examine financing decisions at a higher level of aggregation thanTables 4 and 5. One of our messages is that results for broad aggregates can give amisleading impression of the success of the pecking order, which, after all, is a modelof the financing decisions of individual firms.

If, keeping in mind the caveat discussed earlier, we count only net issues and netrepurchases that exceed 1% of assets, the fractions of each year’s firms that makeannual issues or repurchases that are inconsistent with the pecking order are smallerbut substantial—20.8% for 1973 to 1982, 27.2% for 1983 to 1992, and 31.0% for1993 to 2002. Big firms are again more likely to violate the model than small firms.The firms whose equity issues or repurchases violate the pecking order model bymore than 1% of assets account for 28.1%, 33.1%, and 37.5% of total market equityduring our three ten-year periods.

The summary of pecking order violations in Table 5 is conservative. For example,we classify net repurchases by low-growth firms with positive profitability asconsistent with the pecking order since these firms tend to have financing surplusesand little apparent need for debt capacity. But the debt of these firms averagesaround 50% of assets. If there is any chance that investment opportunities will bemore abundant in the future, in a strict pecking order world these firms would retiremore debt, not equity. About 10% of sample firms are in this category. Moreover,Table 5 ignores dividend status. We argue earlier that net equity issues by dividendpayers are inconsistent with the pecking order, and there are many dividend payersamong the net issuers classified as consistent with the pecking order in Table 5.Finally, many firms issue and repurchase equity in the same year. Though their netissues or repurchases may be consistent with the pecking order, the fact that theyboth issue and repurchase can imply pecking order problems. For example, since thefast-growing firms that make annual net equity issues in Table 4 have a clear demandfor debt capacity, the fact that on average about 25% of them also repurchase is acontradiction of the pecking order, which goes uncounted in Table 5.

6. How do firms issue equity?

The results above raise an obvious question: given that most firms issue someequity every year, what mechanisms do they use? We offer two types of evidence, (i)incomplete results for all sample firms for 1983 to 2002, and (ii) complete results fora sample of big firms (the S&P 100) for three years.

6.1. Partial results for all sample firms

The results for all sample firms are from Thompson Financial’s SDC database,which provides data on mergers, SEOs, and private placements. We suspect thatThompson’s coverage is less complete early in our sample, so we drop 1973 to 1982from the tabulated results. We complement Thompson with Compustat data on cashinflows and outflows from equity sales and repurchases (data items 115 and 108).Recall that cash inflows from the sale of equity are not a good measure of total

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equity issued because they miss stock issues that do not generate cash, such asmergers financed with stock, outright grants of stock to employees, and conversionsof other securities into stock. This variable does, however, include the net cash fromSEOs, private placements, direct purchases, sale of stock to employees, and exercisesof rights and warrants. The results for all sample firms, for small and big firms, andfor the net issuers and net repurchasers in the three groups are in Table 6.

For all groups in Table 6, Compustat’s cash inflow from the sale of equity is largerthan the sum of Thompson’s proceeds from SEOs and private placements. Thedetailed results for the S&P 100 presented later suggest that the difference is dueprimarily to employee option exercises (not on Thompson), but SEOs and privateplacements missed by Thompson may also be a factor. Private placements are largerfor small firms than big firms, but they are always relatively unimportant.

Not surprisingly, firms that make net issues of equity (dSM40) have larger cashinflows from the sale of equity. And the difference between inflows from equity issuesand the sum of SEOs and private placements is larger for net issuers. This suggeststhat net issuers have bigger cash inflows from option exercises by employees. Cashinflows from the sale of equity by small firms that are net issuers are a much largerpercent of assets than for big firms, primarily due to larger SEOs. Still, cash from thesale of equity by big firms that are net issuers is non-trivial, averaging 1.14% and1.30% of the assets of these firms during 1983 to 1992 and 1993 to 2002 (versus amore impressive 3.51% and 5.20% for small firms). For net issuers of equity, stockissued in mergers is much higher for 1993 to 2002 than for 1983 to 1992. The largeincrease in net issues by big firms that are net issuers (from 1.87% to 7.53% of assets)is mostly due to the jump in stock-financed mergers. For small net issuers, SEOs arealso important, averaging 2.11% of assets per year for 1983 to 1992 and 3.48% for1993 to 2002.

Given the importance of SEOs, especially for small firms, and given theimportance of stock-financed mergers during the last ten years of the sample, theevidence on the incidence of mergers and SEOs in Table 6 is interesting. Almost allbig firms and most small firms do one or more acquisitions during each of the table’stwo ten-year periods. On average, more than half of the big firms have an acquisitionin any given year. Not all mergers involve equity financing, however, and evenamong net equity issuers, the fractions of firms that issue stock to finance mergers inany given year are low. For example, equity issued in mergers is substantial during1993 to 2002, but only 12% of the small firms and 19% of the big firms that are netequity issuers in any given year do stock-financed mergers that year.

Similarly, about 30% of small firms and 40% of big firms do an SEO sometimeduring each of the ten-year periods of Table 6, but only about 8% and 11% of thesmall and big net issuers of a given year do an SEO that year. Since proceeds fromSEOs are a larger fraction of assets for small firms than for big firms, we can inferthat though big firms do SEOs more often, the SEOs of small firms tend to berelatively larger.

In sum, SEOs always account for large fractions of the equity issues of small firmsthat make net issues, and stock-financed mergers account for large fractions of theequity issues of the small and big net issuers of 1993 to 2002. But small fractions of

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each year’s net issuers do stock-financed mergers or SEOs. Thus, the distribution ofnet equity issues for any year is skewed right, the result of large issues by the firmsthat do SEOs or stock-financed mergers. We also know, however, that equity issuesexceed 1% of assets for large fractions (58% for 1983 to 1992 and 71% for 1993 to2002) of each year’s net issuers. What is the source of the relatively large equity issuesleft unexplained by SEOs and mergers? Our guess, informed by the more detailedevidence for the S&P 100 that follows, is employee options, grants, and benefit plans.

6.2. Complete results for the S&P 100

Table 7 provides a detailed breakdown of equity issues and repurchases for 1999,2000, and 2001 for firms in the S&P 100 in 2001. (The sample includes only 99 firmsin 1999 because Goldman Sachs did not go public until November of that year.)These firms are special—they are big and successful—and the time period is short,but the advantage of the sample is that the breakdown of equity issues by source isnear complete (hand-collected from annual reports).

Like the full sample, more of the firms in the S&P 100 make net issues than netrepurchases. More important, like firms in the full sample, S&P 100 firms are quiteactive in the equity market. Every firm issues shares every year and most alsorepurchase. (Gross repurchases are positive in 224 of 299 firm-years.) Notsurprisingly, S&P 100 firms that are net issuers of equity have larger equity issuesof all sorts than net repurchasers, whereas the latter, of course, do morerepurchasing. But the interesting fact is that there is lots of issuing and repurchasingin both groups. For these firms, the equity valve is always open, and the flow isalmost always in both directions—hardly the picture one expects to observe in apecking order world (where issues and repurchases are rare).

The equity financing that S&P 100 net issuers get from SEOs, conversion of bondsand other securities into stock, and exercise of warrants and rights is small, butcombined equity financing from these sources averages 0.42% per year of assets forthe three-year sample period. This pales in comparison to equity issues to employees(1.31% per year), which in turn pale relative to equity issued in mergers (6.42% ofassets per year). Thus, as in the results for all big firms that are net issuers of equity,mergers are important, at least in these later years. What we learn in addition fromthe S&P 100 is that stock issues to employees are important and other sources areless important.

S&P 100 firms that make net repurchases also issue substantial stock to employees,though only about half as much (0.73% of assets per year) as net equity issuers(1.31%). For net repurchasers, other kinds of equity issues are small, and equityissues are much more than offset by repurchases. In contrast, less than 10% of theequity issues of net issuers are offset with repurchases. And firms that make netrepurchases do so despite the fact that they issue substantial net new debt. Issuingdebt to repurchase stock is, of course, unacceptable behavior from the perspective ofthe pecking order.

How would the results in Table 7 change if we instead examined a sample of smallfirms? Table 6 says that new equity from SEOs is a larger percent of assets for small

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Table 6

Sources of equity financing for all firms, small firms, and big firms, and for firms making net repurchases (dSMo0) and net issues (dSM40)

Each year’s sample (All firms) includes all non-financial, non-utility firms with the necessary CRSP and Compustat data for that year (see the appendix). The

assets of small and big firms in year t are below or above those of the median NYSE firm in t. The table shows average annual equity financing as a percent of

assets, by source. The sources are mergers, SEOs, and private placements (all from Thompson SDC), and cashflow from sales and repurchases of equity

(Compustat items 115 and 108). The table also shows percents of firms with mergers, equity financed mergers, and SEOs during any year of a subperiod, and

average annual percents per year (This yr.) for each subperiod.

Sources of equity financing as percent of assets Percent of firms with

Cashflow from equity Mergers Equity mergers SEOs

Percent

of firms

dSM/A Mergers SEOs Private

placement

Sale Repur-

chase

Net Any yr. This yr. Any yr. This yr. Any yr. This yr.

Part A: all firms

1983–1992 100.0 0.52 0.35 0.34 0.01 1.05 1.22 �0.17 63.0 20.7 15.6 2.6 31.9 5.7

1993–2002 100.0 3.99 3.33 0.56 0.02 1.30 1.66 �0.36 81.4 34.7 42.3 9.9 33.6 6.3

dSMo0

1983–1992 20.0 �2.32 0.10 0.07 0.00 0.49 2.89 �2.40 72.1 28.8 12.8 1.1 26.6 1.6

1993–2002 19.7 �2.60 0.29 0.09 0.00 0.54 3.49 �2.95 85.9 37.7 32.4 2.5 24.9 1.2

dSM40

1983–1992 62.3 2.33 0.56 0.50 0.02 1.41 0.30 1.11 66.1 22.0 18.9 3.7 37.9 8.3

1993–2002 72.5 8.16 5.35 0.86 0.03 1.79 0.63 1.16 82.0 36.2 47.2 12.9 37.7 8.2

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Part B: small firms

1983–1992 100.0 3.29 0.61 1.54 0.07 2.51 0.96 1.55 57.7 15.9 12.9 2.3 29.5 5.3

1993–2002 100.0 7.93 3.13 2.61 0.14 3.93 1.44 2.49 78.6 29.8 40.2 9.1 32.2 5.9

dSMo0

1983–1992 18.4 �3.40 0.18 0.40 0.01 0.56 3.51 �2.95 66.0 20.8 8.9 0.8 24.4 1.4

1993–2002 17.5 �4.71 0.17 0.45 0.01 0.86 5.12 �4.26 81.8 29.6 27.9 2.0 23.9 1.1

dSM40

1983–1992 61.5 6.04 0.84 2.11 0.09 3.51 0.25 3.25 60.9 17.5 16.2 3.3 35.5 7.9

1993–2002 73.7 12.58 4.38 3.48 0.18 5.20 0.42 4.78 79.7 32.0 45.3 11.9 36.1 7.7

Part C: big firms

1983–1992 100.0 0.22 0.32 0.21 0.01 0.89 1.25 �0.37 93.1 48.7 31.0 4.8 45.3 7.9

1993–2002 100.0 3.52 3.35 0.31 0.00 0.99 1.69 �0.70 95.8 60.0 53.2 13.7 40.7 7.9

dSMo0

1983–1992 29.3 �2.25 0.10 0.05 0.00 0.48 2.86 �2.38 94.5 58.1 27.5 2.0 34.7 2.3

1993–2002 31.4 �2.45 0.30 0.07 0.00 0.52 3.38 �2.86 97.6 61.1 45.1 4.1 27.6 1.7

dSM40

1983–1992 66.6 1.87 0.54 0.31 0.01 1.14 0.31 0.83 93.2 46.5 33.7 6.3 50.5 10.3

1993–2002 66.5 7.53 5.49 0.48 0.00 1.30 0.66 0.64 95.3 60.9 58.4 19.0 47.1 11.0

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Table 7

Components of the change in equity, dSM/A, for all S&P 100 firms, for net issuers (dSM40), and for net repurchasers (dSMo0), 1999–2001

The sample is firms in the S&P 100 in 2001. The ratios for each year are the aggregate value of the numerator divided by the aggregate value of the

denominator, multiplied by 100. The ratios for 1999–2001 are the averages of the annual ratios. The market-based measure of net stock issued, dSM, is the

split-adjusted change in shares outstanding during the fiscal year times the average of the beginning and ending split-adjusted stock prices; dL is the change in

total liabilities during the fiscal year; and dRE is the change in adjusted retained earnings. These variables and the assets used in the denominator of all ratios

are from Compustat. The other data are collected from the individual companies’ annual reports for 1999 to 2001. SEOs is the value of shares sold through

seasoned equity offerings and private placements; Executive compensation is the value of shares issued to employees as part of executive compensation plans,

employee stock option plans, or through the exercise of employee stock options; Mergers is the value of shares issued to complete equity financed mergers;

Convert debt is the value of shares issued through the retirement of debt or the conversion of debt or preferred stock; Exercise warrants is the value of shares

issued through the exercise of warrants and other options not included in Executive compensation and Convert debt; and Share repurchases is the value of

shares acquired for cash or in exchange for other assets. The sample includes only 99 firms in 1999 because Goldman Sachs did not go public until November

of that year.

Firms dSM/A SEOs Executive

compensation

Mergers Convert debt Exercise

warrants

Share

repurchases

dL/A dRE/A

All S&P 100 firms

1999–2001 100 3.57 0.09 1.05 3.68 0.14 0.05 �1.44 10.07 1.37

1999 99 4.37 0.10 1.15 4.55 0.20 0.09 �1.71 9.35 2.34

2000 100 4.29 0.06 1.23 4.31 0.14 0.03 �1.48 13.42 1.51

2001 100 2.05 0.09 0.78 2.19 0.07 0.04 �1.12 7.42 0.25

dSM40

1999–2001 54 7.45 0.14 1.31 6.42 0.22 0.06 �0.70 13.67 1.41

1999 54 10.06 0.20 1.59 8.70 0.38 0.13 �0.94 12.98 3.04

2000 51 8.14 0.07 1.53 7.03 0.17 0.02 �0.68 18.02 1.50

2001 58 4.15 0.15 0.81 3.54 0.11 0.02 �0.47 10.01 �0.33

dSMo0

1999–2001 45 �1.53 0.02 0.73 0.10 0.03 0.05 �2.46 5.05 1.43

1999 45 �1.61 0.00 0.68 0.17 0.01 0.04 �2.51 5.54 1.60

2000 49 �1.74 0.06 0.77 0.05 0.08 0.04 �2.74 6.23 1.53

2001 42 �1.23 0.01 0.73 0.08 0.01 0.07 �2.14 3.39 1.15

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net issuers than for big net issuers. Table 6 also says that net equity issues leftunexplained by mergers and cash inflows from the sale of equity are larger for smallfirms. Although some of the small firms’ unexplained equity issues are probablyomissions from the Thompson database, our bet is that stock issues to employees(not covered by Thompson) are more important for small firms.

7. Discussion and conclusions

The presumption of the pecking order model of Myers (1984) and Myers andMajluf (1984) is that the costs of issuing equity—transactions costs and especially thecosts arising from asymmetric information problems—are high. This is what givesrise to the pecking order itself. Specifically, because the costs of issuing equity arehigh, investments are financed first with retained earnings, then debt, and with equityonly as a last resort. Because debt capacity is valuable for avoiding the costs ofissuing equity, the pecking order model predicts that repurchases of equity are alsorare, and they are restricted to firms with few investment opportunities relative toearnings, and thus little need for debt capacity.

Contradicting these predictions, we find that equity issues are commonplace.During 1973 to 1982, 54% of our sample firms make net equity issues each year,rising to 62% for 1983 to 1992 and 72% for 1993 to 2002. The fractions of firmsmaking gross equity issues are much higher, 67%, 74%, and 86%. Given that equityissues are so pervasive, it is not surprising that they are commonly done by firms thatare not under duress. Repurchases are less common than equity issues, but they arefar from rare. About 20% of sample firms retire equity each year, and the fractionsof firms making gross repurchases are much higher. Moreover, many of the firmsmaking net repurchases have financing deficits that, in a pecking order world, shouldmake debt capacity valuable. In short, our results reject the pecking order’s centralpredictions about how often and under what circumstances firms issue andrepurchase equity.

Equity issues are on average material. During 1983 to 1992 and 1993 to 2002, thenet equity issues of net issuers among small firms are on average larger than their netnew issues of debt. The net equity issues of big firms that are net issuers are aboutone-third the size of their net debt issues during 1983 to 1992, and they are on theorder of net debt issues during 1993 to 2002. The equity issuing process is lumpy,however, resulting in a distribution of issues that is right skewed. Year in and yearout, stock issues to employees are probably the most consistent source of importantamounts of new equity, for big as well as small firms. SEOs are infrequent, but whenthey hit they are large, and they are important in the average annual net stock issues(and thus in the cumulative issues) of smaller firms. Mergers financed with stock arealso infrequent but large, and at least during 1993 to 2002, they are important inaverage annual net issues of stock, especially for bigger firms.

One story for our results is that the pecking order breaks down (equity is not a lastresort) at least in part because there are ways to issue equity with low transactionscosts and modest asymmetric information problems. Three of the alternatives to

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SEOs for issuing equity (issues to employees, rights issues, and direct purchase plans)seem to have both low transactions costs and minor asymmetric informationproblems, and a fourth (mergers financed with stock) may fall into this category. Atleast during the last ten years of the sample period, mergers are important inexplaining the magnitude of equity issues, and issues to employees are probablyimportant in explaining both the magnitude and frequency of issues throughout thesample period.

If there are ways to issue equity that avoid the costs assumed by the pecking order,there is potentially a gaping hole in the model: transactions costs and asymmetricinformation problems may not seriously constrain equity issues. In this case, equityissues are not a last resort, the incentive to avoid repurchases to maintain debtcapacity disappears, and the asymmetric information problems that are the focus ofthe pecking order are not the sole or perhaps even an important determinant ofcapital structures.

Breaking the grip of the pecking order does not require, however, that equitycan be issued with low transactions costs and minor asymmetric informationproblems. Any forces leading to the result that equity is not a last resort will do. Aplausible alternative (or complementary) story is that equity issues often havebenefits that outweigh their costs, i.e., tradeoff considerations. For example,exchanges of stock in mergers often have tax benefits that can offset transactionscosts and any asymmetric information problems. Stock issued to employees mayhave motivation benefits that outweigh issuing costs. In short, any forces that causefirms to systematically deviate from pecking order financing (retained earnings, thendebt, and equity only as a last resort) imply that the pecking order, as the completemodel of capital structure proposed by Myers (1984) and Myers and Majluf (1984),is dead.

Although we disagree with Shyam-Sunder and Myers (1999) about the success ofthe pecking order model, we agree with their conclusion that its main competitor, thetradeoff model, has serious problems. Like asymmetric information, tradeoffconsiderations (for example, the bankruptcy costs of debt) surely play a role infinancing decisions. But there are important aspects of the tradeoff model that getlittle empirical support. For example, the negative relation between leverage andprofitability documented in much previous work (e.g., Kester, 1986; Titman andWessels, 1988; Rajan and Zingales, 1995; Fama and French, 2002) is a seriouscontradiction of the model’s central predictions about the tax and agency benefits ofdebt. The tax benefits of debt in enhancing market values have also proven elusive indirect tests (Fama and French, 1998). Other work (Auerbach, 1985; Jalilvand andHarris, 1984; Fama and French, 2002) suggests that if firms have the leverage targetsposited by the tradeoff model, reversion to the targets is quite slow, leading Shyam-Sunder and Myers (1999) to question the existence of targets. Finally, the surveyevidence of Graham and Harvey (2001) suggests that if firms have leverage targets,the targets are quite soft.

In short, both the tradeoff model and the pecking order model have seriousproblems. Thus, it is probably time to stop running empirical horse races betweenthem as stand-alone stories for capital structures. Perhaps it is best to regard the two

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models as stable mates, with each having elements of truth that help explain someaspects of financing decisions.

Appendix A. Data

The data are from CRSP and Compustat. To be included in the sample forcalendar year t, a firm must have total assets (Compustat item 6) for the last fiscalyear in t and for the previous fiscal year (t�1), liabilities (181) for t and t�1,Compustat’s adjusted value of balance sheet retained earnings (36) for t and t�1,interest expense (15) for t, income before extraordinary items (18) for t, and a stockprice (199) and shares outstanding (25) for the fiscal year-ends in t and t�1.Moreover, the change in the Compustat split adjustment factor (27) from t�1 to t

must match the change implied by the CRSP share factors (FACSHR) for stocksplits and stock dividends (distribution codes 5510–5559) distributed between thefiscal year-ends for t�1 to t. We exclude utilities (SIC codes 4900–4949) and financialfirms (6000–6999).

Our measure of earnings, E, is income before extraordinary items (Compustatitem 18), plus interest expense (15), plus extraordinary income (48) if available. Thefinancing deficit, Def, is the growth in assets (6) minus the change in Compustat’sadjusted value of balance sheet retained earnings (36),

Def ¼ ðAt � At�1Þ � ðREt � REt�1Þ: (A.1)

The book measure of net equity issued, dSB, is the financing deficit, Def, minus thechange in liabilities, dL. Equivalently, it is the change in stockholders’ equity minusthe change in retained earnings,

dSB ¼ Def � dL ¼ dSE � dRE: (A.2)

We compute the market measure of net equity issued, dSM, for fiscal year t as theproduct of (i) the split-adjusted growth in shares and (ii) the average of the split-adjusted stock price at the beginning and end of the fiscal year, both fromCompustat,

dSMt ¼ ðSharest Adjustt � Sharest�1 Adjustt�1Þ

� ðPricet�1=Adjustt�1 þ Pricet=AdjusttÞ=2; ðA:3Þ

where Pricet, Sharest, and Adjustt are the Compustat price, shares outstanding, andsplit adjustment factor at the end of fiscal year t.

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