Meaningful Adjustments in a Financing Based Model of Capital Structure

Abstract

The conventional partial adjustment model, focusing on leverage evolution, has difficulty identifying deliberate capital structure adjustments as financing decisions are confounded with the mechanical autocorrelation of leverage. We propose and estimate a financing-based partial adjustment model that separates the effects of financing decisions on leverage evolution from mechanical evolution. The speed of adjustment (SOA) is firm specific and stochastic, and active targeting of capital structure has a multiplier effect that depends on the size of financial deficit. Overall, expected SOA from active rebalancing (30%) more than doubles what is expected from mechanical mean reversion alone (13%).

Keywords: capital structure, trade-off theory, partial adjustment model, targeting, random financing, speed of adjustment

JEL Classification: G30, G32