Testing Dynamic Tradeoff Theory: Evidence from Rebalancing Points.

Abstract:     
We develop a simple methodology to identify firms that are at or close to their optimal capital structure. Using this methodology we present cross-sectional and time series evidence in favor of dynamic tradeoff theory. In particular, at rebalancing points the relationship between profitability and leverage is positive, consistent with theoretical predictions. Also, the time series of market leverage, profitability, and equity payouts in the years prior to rebalancing events match the patterns obtained from simulated data. Our methodology is robust to recent critiques of empirical tests of dynamic tradeoff theory.

Number of Pages in PDF File: 38

Keywords: empirical corporate finance, capital structure, dynamic tradeoff theory

JEL Classification: G30, G32

working papers series