Capital structure is a key issue fo

Capital structure is a key issue for financial decision makers. Empirical evidence indicates
that firms seek a target debt-equity ratio. The dependence of firms’ leverage ratios
on selected firm characteristics has usually been interpreted in favor of one or the other
standard static capital structure models, e.g., the trade-off theory or the pecking order
theory. However, these modes remain completely silent on the adjustment process towards
the target leverage ratio. Due to random events or other changes, firms may temporarily
deviate from their optimal capital structure, and then only gradually work back
to the optimum. In fact, in the presence of adjustment costs, it might be cheaper for
firms not to fully adjust to their targets even if they recognize that their existing leverage
ratios are not optimal. Nevertheless, there is surprisingly little empirical evidence on
the determinants of a time-varying adjustment speed, and especially about the influence
of macroeconomic variables on the adjustment process.
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We present a simple model that endogenizes both the target leverage ratio and the speed
of adjustment. Using a dynamic adjustment model and panel methodology for a sample
of 90 Swiss firms over the 1991-2001 period, we are able to shed new light (i) the determinants
of the optimal capital structure rather than the observed capital structure and
(ii) the determinants of the adjustment speed. In particular, we analyze the effects of
firm-specific characteristics as well as macroeconomic factors on the speed of adjustment
to the target leverage. We find that faster growing firms and those that are further
away from their optimal capital structure adjust more readily. Our results also reveal
interesting interrelations between the adjustment speed and popular business cycle variables.
Most important, the speed of adjustment is higher when the term spread is higher,
i.e., when economic prospects are good.
However, our work has clear limitations. Possibly due to the small sample size we are
unable to identify differences in the speed of adjustment between financially constrained
and unconstrained firms. Given that a firm’s access to financial markets is expected
to affect its capital structure choice, and financial constraints clearly have a macroeconomic
dimension, this remains an interesting open research question.