In Search of Conclusive Evidence: How to Test for Adjustment to Target Capital Structure
Posted: 21 Jul 2010
Date Written: July 20, 2010
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-eight percent per year.
Keywords: capital structure, target leverage, adjustment to target
JEL Classification: G32
Suggested Citation: Suggested Citation