Reconciling Estimates of the Speed of Adjustment of Leverage Ratios

Abstract

A number of prominent papers in the literature have estimated the average speed of adjustment (SOA) of firms’ leverage ratios with estimators not designed for applications in which the dependent variable is a ratio. These statistics indicate mean reversion, which the papers mistakenly interpreted as deliberate readjustment. We propose a non-parametric way to model leverage ratios under the null hypothesis of random corporate behavior — a placebo process — and embed it with the common alternative of reverting to a target. We show that the empirical estimates previously documented were not only too low, but map into two estimates of the underlying parameter — one with a positive but very slow speed of readjustment, and one with a small negative speed of readjustment (as suggested in Baker and Wurgler (2002) and Dittmar and Thakor (2007)). The best inference to be drawn from the same estimators reported in the literature is the latter, i.e., the true SOA is mildly negative. The average manager does not seem to move back towards a target ratio.

Keywords: Capital Structure, Leverage Ratios, Speed of Adjustment

JEL Classification: G32