Historical Market-to-Book and Past Returns in a Partial-Adjustment Model of Leverage

Historical market-to-book and past returns have been shown to explain current leverage. Prior studies attribute the evidence to market timing or passive management. This study shows that with the presence of time-varying targets and adjustment costs, historical variables have a significant impact on leverage even when firms do not time the market and managers actively rebalance the leverage ratios toward the targets. The historical value of alternative market timing proxies, such as insider sales and market sentiment, are shown to have no effects on leverage while the historical value of alternative growth options proxies do. Overall, the evidence is largely consistent with a partial adjustment model of leverage.