Partial adjustment toward target capital structures

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jfineco.2005.03.004 Byline: Mark J. Flannery (a), Kasturi P. Rangan (b) Keywords: Leverage; Tradeoff theory; Target; Speed of adjustment 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. Author Affiliation: (a) Graduate School of Business, University of Florida, Gainesville, FL 32611-7168, USA (b) Weatherhead School of Management, Case Western Reserve University, Cleveland, OH 44106, USA Article History: Received 12 May 2004; Revised 21 December 2004; Accepted 16 March 2005 Article Note: (footnote) [star] We would like to thank, without implicating, Jay Ritter, Artuno Bris, Ralf Elsas, Vidhan Goyal, Rongbing Huang, Mike Lemmon, Peter MacKay, Sam Thomas, Ivo Welch, Jeff Wurgler, and seminar participants at Arizona State University, the Atlanta Finance Forum, Case Western Reserve University, the Federal Deposit Insurance Corporation, George Mason University, New York University, Southern Methodist University, the University of Texas, and Washington University for comments on previous drafts of this paper. Murray Frank (the referee) provided advice that substantially improved the paper. George Pennacchi and Ajai Singh provided helpful advice about a related paper.