Partial adjustment toward target capital structures

Abstract

The empirical literature provides conflicting assessments about how firms choose their capital structures. Distinguishing among the three main hypotheses (“tradeoff”, pecking order, and market timing) 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 applied empirical specifications that fail to recognize the potential for incomplete adjustment. A more general, partial-adjustment model of firm leverage indicates that firms do have target capital structures. The typical firm closes about one-third of the gap between its actual and its target debt ratios each year.

Introduction

Since Modigliani and Miller's irrelevance proposition in 1958 (Modigliani and Miller, 1958), researchers have investigated firms’ decisions about how to finance their operations. Initially, they asked whether the irrelevance proposition is consistent with the available data, or, whether instead capital market imperfections make firm value depend on capital structure. In the latter case, it was argued, firms would select target debt-equity ratios, trading off their costs and benefits of leverage. Survey evidence by Graham and Harvey (2001) shows that indeed, 81% of firms consider a target debt ratio or range when making their debt decisions. However, alternative theories remain plausible. Myers (1984) contrasts this tradeoff theory of capital structure with an updated version of Donaldson's (1961) pecking order theory, according to which information asymmetries lead managers to perceive that the market generally underprices their shares. Accordingly, investments are financed first with internally generated funds, the firm issues safe debt if internal funds prove insufficient, and equity is used only as a last resort. In a pecking order world, observed leverage reflects primarily a firm's historical profitability and investment opportunities. Firms have no strong preference about their leverage ratios and, a fortiori, no strong inclination to reverse leverage changes caused by financing needs or earnings growth.

Two additional theories of capital structure also reject the notion of timely convergence toward a target leverage ratio. First, Baker and Wurgler (2002) argue that a firm's observed capital structure reflects its cumulative ability to sell overpriced equity shares: that is, share prices fluctuate around their “true” values, and managers tend to issue shares when the firm's market-to-book ratio is high. Unlike the pecking order hypothesis, this market timing hypothesis asserts that managers routinely exploit information asymmetries to benefit current shareholders; like the pecking order hypothesis, there is no reversion to a target capital ratio if market timing is the dominant influence on firm leverage. Second, Welch (2004) argues that managerial inertia permits stock price changes to have a prominent effect on market-valued debt ratios: “... over reasonably long time frames, the stock price effects are considerably more important in explaining debt-equity ratios than previously identified proxies” (p. 107).

The pecking order, market timing, and inertia theories of capital structure imply that managers perceive no great leverage effect on firm value and therefore make no effort to reverse changes in leverage. In contrast, the tradeoff theory maintains that market imperfections generate a link between leverage and firm value, and firms take positive steps to offset deviations from their optimal debt ratios. The speed with which firms reverse deviations from their target debt ratios depends on the cost of adjusting leverage. With zero adjustment costs, the tradeoff theory implies that firms should never deviate from their optimal leverage. At the other extreme, if transaction costs are infinite we should observe no movements toward a target. Baker and Wurgler (2002) emphasize the connection between adjustment costs and observed capital structure:

The basic question is whether market timing has a short-run or a long-run impact. One expects at least a mechanical, short-run impact. However, if firms subsequently rebalance away from the influence of market timing financing decisions, as normative capital structure theory recommends, then market timing would have no persistent impact on capital structure. (page 2, emphasis added)

Estimating the effect of capital adjustment costs is thus a key first step in testing competing theories of capital structure.

The empirical model in this paper accounts for the potentially dynamic nature of a firm's capital structure. The model is general enough that we can test whether there is indeed a leverage target and if so, what is the (adjustment) speed with which a firm moves toward its target. Our evidence indicates that firms do target a long run capital structure, and that the typical firm converges toward its long-run target at a rate of more than 30% per year. This adjustment speed is roughly three times faster than many existing estimates in the literature, and affords targeting behavior an empirically important effect on firms’ observed capital structures. When we add market timing or pecking order variables to our base specification, we do find some support for these theories. However, more than half of the observed changes in capital structures can be attributed to targeting behavior while market timing and pecking order considerations explain less than 10% each. Unlike Welch (2004), we find that stock price changes have only transitory effects on capital structure.

Our findings are not consistent with many recent empirical papers on capital structure (e.g., Shyam-Sunder and Myers, 1999; Baker and Wurgler, 2002; Fama and French, 2002; Huang and Ritter, 2005; Welch, 2004). However, the literature also offers some precedents for our rapid estimated adjustment speeds (Marcus, 1983; Jalilvand and Harris, 1984; Roberts, 2002). We argue that some previous empirical models impose unwarranted, yet testable, assumptions about the adjustment speed and/or the dynamic properties of target leverage. These assumptions materially influence the estimation results and consequently the conclusions drawn. Part of our paper's contribution is to identify why previous research produces such disparate estimated adjustment speeds.

The paper is organized as follows. Section 2 derives our preferred regression specification for testing the tradeoff theory in a partial adjustment framework. Section 3 describes the Compustat—CRSP data we use to estimate our regression models. Section 4 presents our basic results. After showing that our regressions are robust to various estimation methods, we establish the statistical and economic significance of a target debt ratio and relate our results to previous discussions of the tradeoff theory. Section 5 explicitly compares our model to the pecking order, market timing, and inertia models. Section 6 presents a series of robustness tests and the final section concludes. An appendix discusses the econometric issues associated with estimating the dynamic panel regression that constitutes our base specification.