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Back to the Beginning: Persistence and the Cross-Section (...)

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Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure


The choice of capital structure continues to be a fundamental question in financial economics. This study quantify the extent to which existing determinants govern cross sectional and time series variation in observed capital structures by examining the evolution of corporate leverage ratios. 

The primary sample consists of all nonfinancial firm-year observations in the intersection of the monthly CRSP and annual Compustat databases between 1965 and 2003. In each calendar year, the firms are sorted into quartiles (i.e., four portfolios) according to their leverage ratios.

Leverage is regressed upon on firm size, profitability, tangibility, market-to-book, and industry indicator variables.

Leverage ratios exhibit a significant amount of convergence over time; firms with relatively high (low) leverage tend to move toward more moderate levels of leverage. It is also noticed that, despite this convergence, leverage ratios are remarkably stable over time; firms with relatively high (low) leverage tend to maintain relatively high (low) leverage for over 20 years

An analysis of security issuance behavior identifies debt policy as an important mechanism for controlling corporate leverage, while equity policy plays a secondary role. This finding suggests that active management of leverage ratios is at least partially responsible for the mean reversion in leverage ratios.

With respect to persistence of leverage, three sets of analysis are carried out. Firstly the role that firms’ initial leverage ratios play in determining future leverage ratios is examined. Secondly a variance decomposition of leverage to quantify the explanatory power of existing determinants and test for the presence of unobserved firm specific heterogeneity or, loosely speaking, firm fixed effects are performed. Finally traditional empirical specifications using a distributed lag model of leverage is utilized to examine whether the findings are due to managers reacting to shifts in long-run or expected levels of previously identified determinants, as opposed to short-run fluctuations in their values

The results show that leverage contains an important unobserved firm-specific component that is not fully captured by existing determinants. The variance decomposition reinforces the finding that the majority of the total variation in leverage is due to cross-sectional differences, as opposed to time series-variation. Initial leverage ratios play an important role in determining future leverage ratios. Large changes in the long run equilibrium levels of the determinants lead to relatively small changes in the unconditional expectation of leverage.

In conclusion, results suggest that majority of variation in leverage ratios is driven by an unobserved time invariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. This feature of leverage largely unexplained by previously identified determinants, is robust to firm exit, and is present prior to the IPO suggesting that variation in capital structures is primarily determined by factors that remain stable for long periods of time. Static pooled OLS regressions of leverage ratios appear inadequate for dealing with the unobserved heterogeneity present in corporate capital structures. The presence of a significant unobserved transitory component suggests that dynamic specifications are necessary.



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