Capital Structure and Stock Returns: The European Evidence

Abstract

Using a panel of 425 European firms over the period from 1990 to 2005, we revisit Welch's (2004) finding that stock returns are the primary determinant of capital structure changes and that the corporate motives for issuing activities remain largely unexplained. We document that about half of the variation in leverage can be explained by stock return-induced effects over both 1-year and 5-year horizons. In contrast to the US evidence, corporate issuing activities are not as pronounced in our European sample, but they seem nevertheless sufficient for firms to maintain a target debt ratio in the long run. Therefore, our results are also consistent with recent evidence for dynamic rebalancing of the capital structure within a target range in the presence of adjustment costs. In a horse race with stock returns, traditional capital structure variables are inferior in explaining corporate leverage ratios and readjustment in response to return-induced changes in the short run, but they retain a significant role in the long run.

Keywords: Capital structure, dynamic adjustment, panel models

JEL Classification: G24, G32