Testing Theories of Capital Structure and Estimating the Speed of Adjustment

Abstract

This paper examines time-series patterns of external financing decisions and shows that publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. The historical values of the cost of equity capital have long-lasting effects on firms' capital structures through their influence on firms' historical financing decisions. We also introduce a new econometric technique to deal with biases in estimates of the speed of adjustment toward target leverage. We find that firms adjust toward target leverage at a moderate speed, with a half-life of 3.7 years for book leverage, even after controlling for the traditional determinants of capital structure and firm fixed effects.

The Form of Debt and Stock Returns: Empirical Evidence from Oman

“…Similarly, we find that firms with higher Z-scores adjust less frequently compared to firms with lower Z-scores. These results are consistent with Huang & Ritter (2009) who find that firms with lower adjustment costs do not adjust faster than firms with higher adjustment costs. Similarly, Xu (2007) finds that large firms do not appear to adjust more quickly than small firms for the US.…”

“…In general, our result that stock returns are a primary determinant of capital structure is consistent with the recent work by Cai & Zhang (2006), Chen & Zhao (2005), and Kayhan & Titman (2007). The slow adjustment we find is in line with the evidence reported by Jalilvand & Harris (1984), Fama & French (2002), Baker & Wurgler (2002), Titman & Tsyplakov (2007), and Huang & Ritter (2009).…”

“…The proportional cost component is considered relative to the market value of raised or retired debt whereas the fixed cost is independent of the size of the transaction. Due to the fixed cost component, it is commonly argued that larger firms face relatively lower adjustment costs than smaller firms (Huang & Ritter, 2009). Accordingly, we would expect larger firms to adjust their capital structure more frequently (Xu, 2007).…”

“…We examine this issue by splitting our sample into two subsamples depending on whether the firms are smaller or larger than the median firm in the same year. A similar approach is used by Huang & Ritter (2009). We then estimate equation (3) for both subsamples.…”

“…They conclude that dynamic tradeoff theory with transaction costs is not likely to be the main interpretation for Welch's results. In a similar vein, Huang & Ritter (2009) find that the effects of debt and equity issues on both book and market leverage last for more than 10 years, which is inconsistent with Leary & Roberts (2005). Titman & Tsyplakov (2007) develop a dynamic model of capital structure and report evidence that firms adjust their capital structure quite slowly.…”