Common Factors in Corporate Capital Structure

Abstract

This paper reexamines the controversy over capital structure adjustment speed. We show that firms move leverage towards target much faster than generally understood. To do this we use reduced rank regressions to extract 4 common factors for corporate leverage using 146 variables, including value weighted aggregates of standard firm attributes, and macroeconomic variables. Firm specific factor loadings on all of these are estimated. The model provides estimates of time varying leverage targets. More than half of the leverage variation by the median firm is explained, and there is significant predictive ability for several years out-of-sample. Firms actively adjust both debt and equity to move leverage in the direction of the estimated targets. A straw man null hypothesis of purely random financing actions is easily rejected. Slow speeds of adjustment reported in previous studies may reflect the use of static leverage targets while firms actually care about time varying targets.

Keywords: capital structure, leverage target, reduced rank regression, partial adjustment

JEL Classification: C32, G30, G32