Partial Adjustment Toward Target Capital Structures

50 Pages Posted: 10 Jan 2005

See all articles by Mark J. Flannery

Mark J. Flannery

University of Florida - Department of Finance, Insurance and Real Estate

Kasturi P. Rangan

Case Western Reserve University - Department of Banking & Finance

Date Written: May 3, 2004

Abstract

The literature provides conflicting assessments about how firms choose their capital structures, with the "tradeoff", pecking order, and market timing hypotheses all receiving some empirical support. Distinguishing among these theories requires that we know whether firms have long-run leverage targets and (if so) how quickly they adjust toward them. Yet many previous researchers have relied on empirical specifications that fail to recognize the potential impact of adjustment costs on a firm's observed leverage. Likewise, few researchers have incorporated the effect of share price changes on market-valued leverage. We estimate a relatively general, partial-adjustment model of firm leverage decisions, and conclude that firms do have target capital structures. The typical firm closes more than half the gap between its actual and its target debt ratios within two years. 'Targeting' behavior as opposed to market timing or pecking order considerations explains a majority of the observed changes in capital structure.

Keywords: Capital Structure, Partial Adjustment

Suggested Citation

Flannery, Mark Jeffrey and Rangan, Kasturi P., Partial Adjustment Toward Target Capital Structures (May 3, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN: https://ssrn.com/abstract=467941 or http://dx.doi.org/10.2139/ssrn.467941

Mark Jeffrey Flannery (Contact Author)

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-3184 (Phone)
352-392-0103 (Fax)

Kasturi P. Rangan

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3688 (Phone)
216-368-4776 (Fax)

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