The Dynamics of Capital Structure: An Empirical Analysis of a Partially Observable System

This paper examines the dynamic properties of capital structure in a state space framework by modifying the filtering results of Harvey and Stock (1985). A system of stochastic differential equations is used to specify the dynamics for a firm’s debt-toequity ratio (i.e. leverage) and the determinants of capital structure. Statistical issues such as measurement error and missing data are addressed. The results have several significant implications. First, firms are found to systematically adjust their capital structure to a target level. Second, the target level to which firms adjust is a function of firm characteristics. Third, firms take extended excursions away from their target leverage and the rate at which they revert back to the target varies dramatically across industries. Last, measurement error and missing data have a statistically significant but economically small impact on the results. ∗The author would like to thank his thesis supervisor Thomas Rothenberg and David Freedman for invaluable assistance; and George Akerlof, Robert Anderson, Kevin Cole, Roger Craine, Steve Evans, Christopher Knittel, Hayne Leland, Liza Levina, Terry Marsh, Justin McCrary, Lea Popovic, James Powell, Matt Spiegel, Paul Ruud and Wei-kang Wong for helpful comments. All correspondence should be sent to: Department of Economics, 549 Evans Hall #3880, Berkeley, CA 94720-3880. E-mail: [email protected].