A Comparative Analysis of Proxies for an Optimal Leverage Ratio

Posted: 16 May 2009

See all articles by Ranjan D'Mello

Ranjan D'Mello

affiliation not provided to SSRN

Joseph B. Farhat

Central Connecticut State University - Department of Finance

Date Written: August 16, 2008

Abstract

Previous studies that test the tradeoff theory commonly use one of the following debt ratio measures to proxy for a firm's hypothesized optimal ratio: firm's time-series mean leverage, moving average leverage based on a firm's historical debt ratios, industry median leverage, and predicted leverage ratio based on cross-sectional regressions. We find that these alternative proxies yield results that are significantly different from each other. Further, regression results of models that use the optimum target leverage and the conclusions drawn from the findings are sensitive to the model's proxy. Of the proxies that are commonly used in the literature, the moving average debt measure exhibits characteristics that are most consistent with the theoretical optimal leverage ratio.

Keywords: Optimum capital structure, Optimal leverage ratio, Tradeoff theory

JEL Classification: G30, G32, G34

Suggested Citation

D'Mello, Ranjan and Farhat, Joseph, A Comparative Analysis of Proxies for an Optimal Leverage Ratio (August 16, 2008). Review of Financial Economics, Vol. 17, No. 3, 2008, Available at SSRN: https://ssrn.com/abstract=1405662

Ranjan D'Mello (Contact Author)

affiliation not provided to SSRN ( email )

Joseph Farhat

Central Connecticut State University - Department of Finance ( email )

1615 Stanley Street
New Britian, CT 06050
United States

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