Do Firms Rebalance Their Capital Structures?

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  • 1 January 2004
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      • Published in RePEc
Abstract
We empirically examine the trade-off theory of capital structure, allowing for costly adjustment. After confirming that financing behavior is consistent with the presence of adjustment costs, we use a dynamic duration model to show that firms behave as though adhering to a dynamic trade-off policy in which they actively rebalance their leverage to stay within an optimal range. We find that firms respond to changes in their equity value, due to price shocks or equity issuances, by adjusting their leverage over the two to four years following the change. The presence of adjustment costs, however, often prevents this response from occurring immediately, resulting in shocks to leverage that have a persistent effect.We then show that this persistence in leverage is positively correlated with adjustment costs. Our evidence suggests that this persistence is more likely a result of optimizing behavior in the presence of adjustment costs, as opposed to indifference with regard to capital structure.
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