Dynamic Leverage Targets

Through the lens of a dynamic trade-off model of capital structure, we reconcile active capital structure rebalancing and slow average adjustment speeds towards target leverage, both of which have been documented by empirical studies. In the model, firms optimally adjust leverage towards a dynamic target, which is firm specific and responds to evolving firm characteristics and investment opportunities. In the presence of investment frictions and capital market imperfections, firms close only partially the gap that separates their current leverage from their target. Thus, targets are relatively less stable than leverage itself. By means of structural estimation, we show that there is convergence towards dynamic targets in the real data, at faster speed the larger the gap from the target. Over horizons ranging from five to thirty years, targets are roughly twenty to forty percent more volatile than leverage. Adjustment speeds exhibit significant heterogeneity across firms and time, and partial adjustment models that assume constant speed largely underestimate average speeds.