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In search of conclusive evidence: How to test for adjustment to target capital structure

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  • Hovakimian, Armen
  • Li, Guangzhong

Abstract

Simulation experiments show that both partial-adjustment and debt-equity choice models can generate spuriously significant estimates that are consistent with the hypothesis that firms have target debt ratios to which they periodically adjust. Regressions relying on full-sample fixed effects models of target leverage, in particular, produce results severely biased in favor of the target-adjustment hypothesis. Various target proxies and modifications to the standard methodologies are examined to identify partial-adjustment and debt-equity choice models that have power to reject the target-adjustment hypothesis. The resulting estimates of the speed of adjustment are in the range of five-eight percent per year.

Suggested Citation

  • Hovakimian, Armen & Li, Guangzhong, 2011. "In search of conclusive evidence: How to test for adjustment to target capital structure," Journal of Corporate Finance, Elsevier, vol. 17(1), pages 33-44, February.
    • Handle: RePEc:eee:corfin:v:17:y:2011:i:1:p:33-44
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