Do Firms Rebalance Their Capital Structures?

We empirically examine whether firms engage in a dynamic rebalancing of their capital structures while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for corporate financial policy and the interpretation of previous empirical results. After confirming that financing behavior is consistent with the presence of adjustment costs, we find that firms actively rebalance their leverage to stay within an optimal range. Our evidence suggests that the persistent effect of shocks on leverage observed in previous studies is more likely due to adjustment costs than indifference toward capital structure. A TRADITIONAL VIEW IN CORPORATE FINANCE is that firms strive to maintain an optimal capital structure that balances the costs and benefits associated with varying degrees of financial leverage. When firms are perturbed from this optimum, this view argues that companies respond by rebalancing their leverage back to the optimal level. However, recent empirical evidence has led researchers to question whether firms actually engage in such a dynamic rebalancing of their capital structures. Fama and French (2002), among others, note that firms’ debt ratios adjust slowly toward their targets. That is, firms appear to take a long time to return their leverage to its long-run mean or, loosely speaking, optimal level. Moreover, Baker and Wurgler (2002) document that historical efforts to time equity issuances with high market valuations have a persistent impact on corporate capital structures. This fact leads them to conclude that capital structures are the cumulative outcome of historical market timing efforts, rather than the result of a dynamic optimizing strategy. Finally, Welch (2004) finds that equity price shocks have a long-lasting effect on corporate capital structures as well. He concludes that stock returns are the primary determinant of capital structure changes and that corporate motives for net issuing activity are largely a ∗Mark Leary is at The Fuqua School of Business, Duke University and Michael Roberts is at The Wharton School, University of Pennsylvania. We thank Malcolm Baker, Michael Bradley, Qi Chen, Murray Frank, David Hsieh, Roni Michaely, Sendhil Mullainathan, Mitchell Petersen, Gordon Phillips, Emma Rasiel, Oded Sarig, Robert Stambaugh (the editor), Karin Thorburn, Vish Viswanathan, Jose Wynne; seminar participants at Duke University, Harvard University, Interdisciplinary Center of Herzliya, University of North Carolina at Chapel Hill, University of Pennsylvania; participants at the 2003 Financial Economics and Accounting Conference, the 2004 Econometric Society Meetings, the 2004 Southwestern Finance Association, the 2004 Midwest Finance Association, the 2004 Utah Winter Finance Conference, the 2004 Western Finance Association, the 2004 Tuck Corporate Finance Conference; and especially an anonymous referee, Alon Brav, and John Graham for helpful comments.