In Search of Conclusive Evidence: How to Test for Adjustment to Target Capital Structure

Abstract:     
Simulation experiments show that both partial adjustment and debt-equity choice models can generate spuriously significant estimates that are consistent with the hypothesis that firms have target debt ratios to which they periodically adjust. Regressions relying on full-sample fixed effects models of target leverage, in particular, produce results severely biased in favor of the target adjustment hypothesis. Various target proxies and modifications to the standard methodologies are examined to identify partial-adjustment and debt-equity choice models that have power to reject the target adjustment hypothesis. The resulting estimates of the speed of adjustment are in the range of five-thirteen percent per year.

Keywords: capital structure, target debt ratio, target leverage, target adjustment, partial adjustment

JEL Classifications: G32

Working Paper Series