Since Modigliani/Miller’s famous theorem (1958) that capital structure is irrelevant for firm valuation, firms’ capital structure choice has been one of the most significant subjects in the modern finance theory. The subsequent theoretical literature has found evidence to negate the irrelevance theorem. Most empirical studies applied a static framework and are capable to explain differences in the optimal leverage ratios across firms, using observed leverage ratios as proxies for the optimal target leverage, but do not explain observed differences in firms’ leverage ratios itself. One broadly accepted reason for a firm’s deviation from their target leverage ratio is the existence of adjustment costs. In the presence of adjustment costs, firms may deviate from their target leverage and find it not cost effective to adjust their leverage ratio frequently or fully within one period, even if they recognize that their existing capital structure is not optimal. This shows the need for developing and using a dynamic approach in order to examine firms’ capital structure.
The paper is organized as follows. Section 2 provides a brief overview of the three main theories of capital structure. Section 3 specifies the dynamic partial-adjustment model and describes the variables that may affect the target capital structure as well as the adjustment speed. Section 4 reports the empirical results and Section 5 concludes the paper
Table of Contents
1. Introduction
2. Theories on capital structure
2.1. Trade-off theory
2.2. Other theories on capital structure
3. The dynamic framework
3.1. The two-stage dynamic partial-adjustment capital structure model
3.2. Definitions of leverage
3.3. Determinants of the target leverage
3.4. Determinants of the speed of adjustment
4. Empirical analysis
4.1. Data description
4.2. Descriptive statistics of observed leverage ratios
4.3. Determinants of the target leverage
4.4. Determinants of the speed of adjustment
5. Conclusion
Research Objectives and Key Topics
This paper examines the dynamics of capital structure within German industries between 1991 and 2009. The primary research objective is to analyze the determinants of firms' target leverage ratios and to investigate the speed at which firms adjust their actual capital structures toward these optimal targets using a two-stage dynamic partial-adjustment model.
- Theoretical foundations of capital structure (Trade-off, Pecking order, and Market timing).
- Methodological application of the two-stage dynamic partial-adjustment model.
- Identification of firm-specific determinants affecting target leverage, such as growth, profitability, and size.
- Analysis of factors influencing the speed of adjustment across different industry sectors.
- Empirical evaluation of market and book leverage ratios for German companies.
Excerpt from the Book
3.1. The two-stage dynamic partial-adjustment capital structure model
An appropriate and commonly used model in the finance literature to measure the speed of adjustment is the two-stage dynamic partial-adjustment model. The first-stage can be written as follows:
Stage 1 D* i,t = beta X t-1, (1)
where D* i,t denotes a firm’s i desired target leverage ratio, X t-1 is a vector of firm characteristics related to costs and benefits that determine a firm’s desired target leverage, and beta represents a coefficient vector. The data of all firms are pooled and the parameters of equation (1) are estimated by applying simple ordinary least squares (OLS). Using simple OLS with panel data is called a pooled OLS regression. It is subject to a large number of error types, but it is a simple and quick benchmark to which more sophisticated regressions can be compared. Practically, I put all data together and do not make any distinction between cross-section and time series. The firms’ historical leverage ratios are employed as dependent variable. In a further step, I use the estimated equation to determine the target leverage ratios D* i,t for each firm. Before running the second-stage regression, I classify each firm of my sample into its major industry group.
Summary of Chapters
1. Introduction: This chapter introduces the irrelevance of capital structure as per Modigliani/Miller and identifies the need for dynamic models due to adjustment costs in real-world firm financing.
2. Theories on capital structure: This section provides an overview of the three core theoretical frameworks—the trade-off theory, the pecking order theory, and the market timing hypothesis—that inform modern finance.
3. The dynamic framework: This chapter details the two-stage model used to measure target leverage and adjustment speeds, while defining the leverage metrics and the firm-specific variables influencing these outcomes.
4. Empirical analysis: This chapter presents the data set of 539 German firms, outlines the descriptive statistics, and reports the findings regarding the determinants of target leverage and the speeds of adjustment across industries.
5. Conclusion: This chapter summarizes the key empirical findings, confirming the significance of firm-specific determinants and highlighting the variation in adjustment speeds across different German industry sectors.
Keywords
Capital structure, target leverage, speed of adjustment, trade-off theory, pecking order theory, German industries, market leverage, book leverage, empirical analysis, panel data, pooled OLS, firm-specific determinants, financial distress, adjustment costs.
Frequently Asked Questions
What is the fundamental focus of this research?
The research focuses on the capital structure dynamics of German firms, specifically investigating how they determine their target leverage and how quickly they adjust to reach it.
Which theoretical frameworks are identified as central to the study?
The study primarily utilizes the trade-off theory, the pecking order theory, and the market timing hypothesis to explain capital structure choices.
What is the primary research goal?
The goal is to determine the factors affecting target leverage ratios and to measure the speed of adjustment toward these targets for firms across various German industries from 1991 to 2009.
Which scientific method is employed for the analysis?
The author employs a two-stage dynamic partial-adjustment model, utilizing pooled OLS regression to estimate parameters for both the target leverage and the speed of adjustment.
What topics are discussed in the main body of the work?
The main body discusses capital structure theories, the mathematical framework of the two-stage model, definitions of leverage (market vs. book value), and an empirical analysis of firm-specific determinants like growth, size, and tangibility.
Which keywords best characterize the study?
Key terms include capital structure, target leverage, speed of adjustment, German industries, trade-off theory, and firm-specific determinants.
How does firm size affect the speed of adjustment according to the author?
Contrary to the initial expectation of a positive relationship, the author finds an inverse relationship between size and speed of adjustment, suggesting smaller firms adjust faster, potentially due to tighter bank covenants.
What conclusion does the author draw regarding the 'distance' variable?
The author concludes that the distance between actual and target leverage has no significant impact on the speed of adjustment, suggesting that frequent, small adjustments are more cost-effective than large ones.
- Quote paper
- Christian Weidinger (Author), 2010, Target leverage and capital structure adjustment speed across German industries, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/183708
