Trade-Off, Timing, and Capital Structure
38 Pages Posted: 15 Jun 2006
Date Written: June 2006
The trade-off theory posits that firms seek to maintain a target capital structure and the market timing hypothesis suggests that managers are able to recognize and exploit stock misvaluation when they recapitalize. Jointly, these theories imply that deviations from target leverage reflect stock mispricing. Our results strongly support this view. We find that firms that are over-levered relative to their target outperform under-levered firms by roughly five percent per year over the next three to five years. The results hold for firms that issue debt or equity as well as for non-issuers. Our findings indicate that firms' capital structure choice is best understood using a combination of trade-off and market timing theories.
Keywords: capital structure, market timing, target debt ratio, trade-off
JEL Classification: G32
Suggested Citation: Suggested Citation