SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: The common approach in empirical capital structure research has been to study the determinants of optimal leverage by studying the association between observed leverage and a set of explanatory variables. This approach has two major shortcomings. First, the observed leverage need not necessarily be the optimal leverage. Second, the empirical analyses, being effectively non-dynamic, are unable to shed any light on the nature of dynamic capital structure adjustment by firms. In this paper, we use a dynamic adjustment model, and panel data methodology on a sample of UK and US firms to specifically establish the determinants of a time-varying optimal capital structure. In addition, the model allows for the possibility that at any point in time firms' observed leverage may not be optimal, and that firms differ in their speed of adjustment towards the optimal capital structure, which itself may be changing over time for the same firm. We also attempt to identify factors determining the speed of adjustment. We find that firms typically have capital structures that are not at the target, and that they adjust very slowly towards the target.

Keywords: Capital structure; dynamic adjustment; optimal leverage; firms; panel data

JEL-codes: C23; C51; G32

21 pages, First version: September 21, 1999. Revised: August 21, 2000. Earlier revisions: May 12, 2000, August 21, 2000, August 21, 2000.

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Published as

Saugata Banerjee, Almas Heshmati and Clas Wihlborg, (2004), 'The Dynamics of Capital Structure', Research in Banking and Finance, vol 4, no 1, pages 275-297

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