Do Tests of Capital Structure Theory Mean What They Say?

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Abstract
In the presence of frictions firms adjust their capital structure only infrequently. As a consequence, in a dynamic economy the leverage of most firms, most of the time, is likely to differ from the optimum leverage at the time of readjustment. This paper explores the empirical implications of this observation. A calibrated dynamic trade-off model with adjustment costs is used to simulate firms' capital structure paths. The results of standard cross-sectional tests on this data are found to be qualitatively - and, in some cases, even quantitatively - consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results would lead to the rejection of the model used to generate the data. The framework can explain a number of observed puzzles related to leverage. In particular, in the simulated cross-sectional samples leverage: (a) is inversely related to profitability; (b) can be largely explained by stock returns; (c) is mean-reverting. The results suggest that, in the presence of infrequent adjustment, cross-sectional properties of economic variables in dynamics may be fundamentally different from those derived assuming that they are always at their target levels. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.