Do Firms Rebalance their Capital Structure?

We empirically examine the trade-off theory of capital structure, allowing for infrequent adjustment. After showing that the behavior of financing decisions (security issuances and retirements) is consistent with direct evidence on external financing costs, we use a dynamic duration model to show that firms behave as though adhering to a dynamic trade-off policy in which they actively rebalance their leverage to stay within an optimal range. Financing decisions are sensitive to both the level of and change in leverage, as well as past financing decisions, in a manner consistent with that predicted by Fischer, Heinkel and Zechner (1989). Additionally, we find that firms fully respond to equity issuances and stock price run-ups by increasing their leverage back to pre-issue/run-up levels within two years. Our results run counter to the predictions of the market timing (Baker and Wurgler (2002)) and inertia (Welch (2003)) hypotheses, which imply no such rebalancing. ∗We thank Michael Bradley, Alon Brav, Qi Chen, David Hsieh, Roni Michaely, Sendhil Mullainathan, Gordon Phillips, Emma Rasiel, Oded Sarig, Vish Viswanathan, seminar participants at Fuqua, UNC Chapel Hill and Interdisciplinary Center in Herzilya, and especially John Graham for helpful comments. All remaining errors are our own. Send correspondence to Michael R. Roberts, The Fuqua School of Business, Duke University, Box 90120, Durham, NC 27708-0120. Email: [email protected] The trade-off theory of capital structure posits that firms have an optimal or target debt-to-equity ratio that perfectly balances the costs and benefits of debt financing. The costs of debt financing include the potential for costly bankruptcy and agency conflicts. The benefits include the tax deductability of interest payments and the mitigation of free cash flow problems. While originally conceived as a static theory, a natural implication of the trade-off theory is the dynamic rebalancing of one’s capital structure. Over time, both the target and actual leverage of a firm may change as a result of changes in the characteristics of the firm or market perturbations to the value of debt and equity. If this results in a firm’s actual capital structure deviating from the target, the trade-off theory predicts that the firm adjusts its capital structure in order to equate its actual leverage with the optimal leverage. Recent studies by Baker and Wurgler (2002) and Welch (2003) question whether firms engage in this capital structure rebalancing. Baker and Wurgler (2002) argue that the impact of firms’ efforts to time equity markets is highly persistent, so that capital structure is the cumulative result of these timed trips to the equity market. Welch (2003) argues that, despite fairly active net issuing activity, corporate motives for financial policy are largely a mystery and stock returns are the primary known determinant of debt-equity dynamics. Both theories suggest that firms fail to rebalance their capital structures in response to changes in their leverage brought on by either timed equity issuances or market perturbations to equity values. One problematic aspect of the trade-off theory and many corresponding empirical tests is their assumption of frictionless capital markets. In the absence of adjustment costs, the trade-off theory predicts that firms continuously adjust their capital structures to maintain the value-maximizing leverage ratio. Yet Smith (1986) discusses the scale economies associated with overcoming the fixed cost in issuing securities, while Lee et al. (1996) estimate that the total direct costs of issuing debt and equity range from 2 to 13% of the total proceeds. More recently, Altinkiliç and Hansen (2000) estimate cost functions associated with issuing debt and equity and find that the cost of external finance consists of two components: a fixed component possibly associated with administrative, filing and legal fees, and an increasing variable component reflecting the difficulty of placing larger issues. Thus, while there are economies of scale to overcoming the fixed cost component, there are diseconomies of scale associated with the increasing variable cost component. In the presence of such costs, firms may not find it optimal to respond immediately to shocks that push them away from their target leverage ratios. If the costs of such adjustments outweigh the benefits, firms will wait to recapitalize, resulting in “extended