Capital Structure Dynamics and Transitory Debt

Abstract:     
We estimate a dynamic capital structure model in which firms have permanent leverage targets, yet respond to shocks to investment opportunities by incurring transitory debt obligations that represent deliberate, but temporary, deviations from target. Target capital structures reflect the value of the option to issue transitory debt, and the average amount of debt outstanding differs predictably from target as a function of the attributes of investment opportunities. The model yields testable predictions about the link between capital structure and the volatility and serial correlation of investment opportunity shocks, the marginal profitability of investment, and the nature of capital stock adjustment costs. The leverage ratios implied by our estimated model parameters exhibit slow average speed of adjustment to target similar to the estimates in prior empirical studies. Sluggish adjustment reflects deliberate transitory deviations from target leverage and not costs of debt issuance.

Keywords: capital structure, leverage dynamics, target leverage, transitory debt, financial flexibility

JEL Classifications: G32, G31, D21, D92, E22, H25

Working Paper Series