The Tortoise and the Snail: Reconciling the Evidence on Capital Structure Stability
46 Pages Posted: 2 Nov 2017 Last revised: 15 May 2019
Date Written: May 11, 2019
We reconcile two seemingly contrasting empirical facts, active capital structure rebalancing and slow adjustments towards target leverage, through the lens of a standard dynamic capital structure model. In the model, firms adjust leverage towards a dynamic target, which is firm specific and responds to changes in firms' characteristics and investment opportunities. Capital market imperfections make leverage more stable than target leverage, generating slow adjustments despite active capital structure rebalancing. We quantify the extent of convergence towards dynamic targets by means of structural estimation. Although neither leverage ratios nor leverage targets are moving fast|making it a race between a tortoise and a snail - we find that leverage targets are roughly twenty to forty percent more volatile than leverage ratios over horizons ranging from five to thirty years. Adjustment speeds exhibit significant heterogeneity across firms and time. Standard reduced-form partial adjustment models neglect this property and, as a consequence, largely underestimate average speeds of adjustment.
Keywords: target leverage, dynamic leverage adjustments, capital structure stability, leverage spikes
JEL Classification: G30, G32
Suggested Citation: Suggested Citation