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Murray Z. Frank, Vidhan Goyal, and Tao Shen

The pecking order theory of corporate capital structure developed by states that issuing securities is subject to an adverse selection problem. Managers endowed with private information have incentives to issue overpriced risky securities. But they also understand that issuing such securities will result in a negative price reaction because rational investors, who are at an information disadvantage, will discount the prices of any risky securities the firm issues. Consequently, firms follow a pecking order: use internal resources when possible; if internal funds are inadequate, obtain external debt; external equity is the last resort. Large firms rely significantly on internal finance to meet their needs. External net debt issues finance the minor deficits that remain. Equity is not a significant source of financing for large firms. By contrast, small firms lack sufficient internal resources and obtain external finance. Although much of it is equity, there are substantial issues of debt by small firms. Firms are sorted into three portfolios based on whether they have a surplus or a deficit. About 15% of firm-year observations are in the surplus group. Firms primarily use surpluses to pay down debt. About 56% of firm-year observations are in the balance group. These firms generate internal cash flows that are just about enough to meet their investment and dividend needs. They issue debt, which is just enough to meet their debt repayments. They are relatively inactive in equity markets. About 29% of firm-year observations are in the deficit group. Deficits arise because of a combination of negative profitability and significant investments in both real and financial assets. Some financing patterns in the data are consistent with a pecking order: firms with moderate deficits favor debt issues; firms with very high deficits rely much more on equity than debt. Others are not: many equity-issuing firms do not seem to have entirely used up the debt capacity; some with a surplus issue equity. The theory suggests a sharp discontinuity in financing methods between surplus firms and deficit firms, and another at debt capacity. The literature provides little support for the predicted threshold effects. The theoretical work has shown that adverse selection does not necessarily lead to pecking order behavior. The pecking order is obtained only under special conditions. With both risky debt and equity being issued, there is often scope for many equilibria, and there is no clear basis for selecting among them. A pecking order may or may not emerge from the theory. Several articles show that the adverse selection problem can be solved by certain financing strategies or properly designed managerial contracts and can even disappear in dynamic models. Although adverse selection can generate a pecking order, it can also be caused by agency considerations, transaction costs, tax consideration, or behavioral decision-making considerations. Under standard tests in the literature, these alternative underlying motivations are commonly observationally equivalent.


Jesús Gonzalo and Jean-Yves Pitarakis

Predictive regressions are a widely used econometric environment for assessing the predictability of economic and financial variables using past values of one or more predictors. The nature of the applications considered by practitioners often involve the use of predictors that have highly persistent, smoothly varying dynamics as opposed to the much noisier nature of the variable being predicted. This imbalance tends to affect the accuracy of the estimates of the model parameters and the validity of inferences about them when one uses standard methods that do not explicitly recognize this and related complications. A growing literature aimed at introducing novel techniques specifically designed to produce accurate inferences in such environments ensued. The frequent use of these predictive regressions in applied work has also led practitioners to question the validity of viewing predictability within a linear setting that ignores the possibility that predictability may occasionally be switched off. This in turn has generated a new stream of research aiming at introducing regime-specific behavior within predictive regressions in order to explicitly capture phenomena such as episodic predictability.


The Hou–Xue–Zhang q-factor model says that the expected return of an asset in excess of the risk-free rate is described by its sensitivities to the market factor, a size factor, an investment factor, and a return on equity (ROE) factor. Empirically, the q-factor model shows strong explanatory power and largely summarizes the cross-section of average stock returns. Most important, it fully subsumes the Fama–French 6-factor model in head-to-head spanning tests. The q-factor model is an empirical implementation of the investment-based capital asset pricing model (the Investment CAPM). The basic philosophy is to price risky assets from the perspective of their suppliers (firms), as opposed to their buyers (investors). Mathematically, the investment CAPM is a restatement of the net present value (NPV) rule in corporate finance. Intuitively, high investment relative to low expected profitability must imply low costs of capital, and low investment relative to high expected profitability must imply high costs of capital. In a multiperiod framework, if investment is high next period, the present value of cash flows from next period onward must be high. Consisting mostly of this next period present value, the benefits to investment this period must also be high. As such, high investment next period relative to current investment (high expected investment growth) must imply high costs of capital (to keep current investment low). As a disruptive innovation, the investment CAPM has broad-ranging implications for academic finance and asset management practice. First, the consumption CAPM, of which the classic Sharpe–Lintner CAPM is a special case, is conceptually incomplete. The crux is that it blindly focuses on the demand of risky assets, while abstracting from the supply altogether. Alas, anomalies are primarily relations between firm characteristics and expected returns. By focusing on the supply, the investment CAPM is the missing piece of equilibrium asset pricing. Second, the investment CAPM retains efficient markets, with cross-sectionally varying expected returns, depending on firms’ investment, profitability, and expected growth. As such, capital markets follow standard economic principles, in sharp contrast to the teachings of behavioral finance. Finally, the investment CAPM validates Graham and Dodd’s security analysis on equilibrium grounds, within efficient markets.