Capturing Heterogeneity in Leverage∗

Large heterogeneity has prevented current capital structure research from explaining variations in firms’ capital structures to a satisfactory degree. We find that firms generally fall into two categories based on their capital structure policies. One category consists of larger firms that tend to pay dividends, and includes almost all zero-leverage firms in the sample. These firms tend to respond to temporary increases in capital expenditures by rasing their leverage, but maintain low leverage levels overall. The other category exhibits a relatively larger sensitivity of leverage to temporary changes in firm characteristics. While maintaining the spirit of current capital structure research, we propose a statistical model of leverage that captures the two categories and separates the cross-sectional and time series impacts of leverage factors. Our model not only doubles the explanatory power of a standard capital structure regression without adding much complexity, but also provides new insights into the relationship between leverage and profitability, as well as capital expenditures. ∗Acknowledgments: We are grateful to Alex Butler, Rongbing Huang, Jennifer Juergens, Mark Kamstra, Robert Kieschnick, Michael Lemmon, Michael Roberts, Oleg Rytchkov, Jamie Zender, conference participants at 2008 UBC Finance Winter Conference, 2008 Asia FMA conference, and seminar participants at UT Dallas for helpful comments. †School Of Management, The University of Texas at Dallas, PO Box 688, Richardson, Texas 75080; Email: [email protected] ‡School Of Management, The University of Texas at Dallas, PO Box 688, Richardson, Texas 75080; Email: [email protected]