Do Firms Have Target Leverage Ratios? Evidence from Historical Market-to-Book and Past Returns

Abstract

Several recent empirical studies in the capital structure literature challenge the traditional trade-off theory. Specifically, these studies document that historical market-to-book and past returns can explain cross-sectional leverage. These findings seem to be inconsistent with the existence of a target leverage ratio. In this paper, I show that the historical variables obtain their explanatory power from time-varying target leverage ratios and adjustment costs. The results are more consistent with a dynamic trade-off theory with adjustment costs.

Keywords: capital structure, trade-off theory, market-timing

JEL Classification: G3, G32