Deviation from Target Capital Structure, Cost of Equity and Speed of Adjustment

Forthcoming in Journal of Corporate Finance, doi:10.1016/j.jcorpfin.2016.06.002

Posted: 22 Jun 2016

See all articles by Qing Zhou

Qing Zhou

Department of Applied Finance and Actuarial Studies, Macquarie University

Kelvin Jui Keng Tan

University of Queensland - Business School; Financial Research Network (FIRN)

Robert W. Faff

University of Queensland

Yushu Zhu

University of Queensland - Business School

Date Written: June 15, 2016

Abstract

In this paper, we analyze the impact of leverage deviation (i.e., actual minus target optimal leverage) on the implied cost of equity capital. Our special focus is on whether (and to what extent) the sensitivity of the cost of equity to leverage deviation, influences the speed with which firms adjust their financial leverage towards the target. Confirming theoretical predictions, we find that the cost of equity is positively related to leverage deviation and that firms whose cost of equity is more sensitive to leverage deviation exhibit faster speed of adjustment towards target. Collectively, our findings imply that capital structure targeting is not equally important to all firms. Indeed, we argue that while evidence of the trade-off theory will tend to be obscured in broad samples, it can hold strongly in meaningfully chosen sub-samples of firms - namely, those characterized by high sensitivity of equity cost to leverage deviation.

Keywords: Leverage deviation, sensitivity, cost of equity, speed of adjustment

JEL Classification: G32

Suggested Citation

Zhou, Qing and Tan, Kelvin Jui Keng and Faff, Robert W. and Zhu, Yushu, Deviation from Target Capital Structure, Cost of Equity and Speed of Adjustment (June 15, 2016). Forthcoming in Journal of Corporate Finance, doi:10.1016/j.jcorpfin.2016.06.002. Available at SSRN: https://ssrn.com/abstract=2798476

Qing Zhou (Contact Author)

Department of Applied Finance and Actuarial Studies, Macquarie University ( email )

Sydney, NSW
Australia

Kelvin Jui Keng Tan

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Robert W. Faff

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

Yushu Zhu

University of Queensland - Business School ( email )

Blair Drive
Brisbane
Australia

HOME PAGE: http://https://www.business.uq.edu.au/staff/yushu-elizabeth-zhu

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