The Dynamics of Capital Structure: An Empirical Analysis of a Partially Observable System

Abstract

This paper examines the dynamic properties of capital structure in a state-space framework. A system of stochastic differential equations is used to specify the dynamics for a firm's debt-to-equity ratio and the determinants of capital structure. The framework addresses statistical issues such as measurement error, missing data and endogeneity. There are several important results. First, firms gradually adjust their capital structure to a firm-specific, time-varying target, as opposed to a fixed level or industry average. Second, the rate at which they revert back to the target depends on several factors: the current position of their leverage relative to the target, their industry, and their financial health. Finally, the statistical issues have a significant impact on the results and subsequent conclusions. The primary economic conclusion is that observed financing behavior may be driven by concerns over credit-worthiness and access to external funds.

Keywords: Capital Structure, Leverage, Dynamics, Kalman Filter

JEL Classification: G32, G33, C33