That firms mean-revert their debt-ratios over time is widely supported empirically (Taggart 1977, Jalilvand & Harris 1984). More recently, Fama & French (2002) show firm- specific debt-ratios to be very slowly mean-reverting at a rate between 0.07 and 0.18 per annum. Frank & Goyal (2003) find the average firm debt-ratio mean-reverts at 0.124 per annum on average. For small firms the rate was faster at 0.115 and slower for large firms slower at 0.104.
What is unclear is whether leverage mean-reversion evidence supports the trade-off theory or dynamic pecking order theory. If it is the latter, then the endogenous boundary model literature is misspecified since it relies upon the existence of an optimal debt level, whether it be to maximise firm value or shareholder wealth. Shyam-Sunder & Myers (1999) show that such slow rates of debt-ratio mean-reversion can also be explained by the dynamic pecking order theory. They are unable to reject the dynamic pecking order model because such a slow rate may be due to autocorrelated net cash flows or from firms reserving debt capacity for future financial flexibility as posited in the dynamic pecking order theory. The slowness of reversion is attributed to management giving low priority to maintaining a target debt-ratio; an opinion supported by a qualitative survey of financial controllers undertaken by Graham & Harvey (2001).
Baker & Wurgler (2002) reject both the pecking order and trade-off theories. They argue that if the trade-off theory holds, temporary fluctuations in the market-to-book ratio, or any other variable, should have temporary effects. However, their finding of statistically robust persistence in past equity returns is not consistent with dynamic debt management under the trade-off theory. Only an exogenous boundary model, such as CDG and Demchuk & Gibson (2006), is consistent with the market timing theory. That Graham & Harvey (2001) find that two-thirds of surveyed Chief Financial Officers claim market timing influences their sourcing of funding, supports market timing behaviour as the predominant explanatory model of the firm’s dynamic capital structure. If mar- ket timing is the main capital structure behaviour, then only an exogenous boundary structural credit model conditioned on past equity returns would be consistent with the empirical literature supporting market timing behaviour.
That past stock prices influence firm leverage is supported by Welch (2004). He finds that firm leverage ratios are are strongly negatively related to past stock returns, which
is inconsistent with the trade-off theory’s prediction that firms will increase leverage to revert to a static debt-ratio in response to decreasing market leverage. Using a variation of Baker & Wurgler’s (2002) market timing variable, Kayhan & Titman (2007) confirm that historical stock price changes and external funding deficits have a significant effect on capital ratios over the short to medium term, but in the longer term there is evidence of partial reversion back to target ratios based on traditional trade-off variables. Firms are found to raise equity capital when their stock prices are high and tend to reduce their debt-ratios subsequently. The persistence of the equity market influence partially persists for up to 10 years.
Frank & Goyal (2003) and Fama & French (2002) argue that firms with more asym- metric information should follow the pecking order of funding sources more closely. However, small high growth firms issue significant amounts of equity, in contradiction of the pecking order theory. In contrast, the pecking order theory explains well the equity issuance of large mature firms. The result is explainable if capital constraints are consid- ered in the context of a dynamic pecking order model. Lemmon & Zender (2002) find that small high growth firms carry additional equity due to the presence of debt capacity constraints. Similarly, Dissanaike, Lambrecht & Saragga (2001) show, on a sample of UK firms, that those that did not target a debt-ratio were on average larger, more prof- itable, have higher market-to-book ratios, and carry more tangible assets, than firms that did target a debt-ratio. Debt targeting may therefore be a consequence of concern over managing future debt capacity.
Instead of firm size, Chang, Dasgupta & Hilary (2006) use equity analyst coverage as a proxy for information asymmetry. They find that firms with low coverage and high information asymmetry, are more affected by Baker & Wurgler’s (2002) external finance weighted market-to-book ratio. In other words, these firms seek external funds when their share price is high relative to recent history. The implication is that firms with high information asymmetry, including small firms, will have term structures of credit spreads that reflect the potential to re-leverage based on the expected evolution of market equity returns.
Korajczyk & Levy (2003) consider the influence of macroeconomic conditions on firm leverage and show that it affects firm behaviour via market timing subject to capital constraints. Empirically they find that unconstrained firms are more sensitive to market conditions and are more likely to issue equity when the recent average stock price is high. A constrained firm is defined as not having sufficient cash to undertake investment opportunities and faces severe agency costs when accessing financial markets. Con- strained firms are more influenced by the deviation from firm-specific target, exhibiting faster reversion, and were only marginally affected by macroeconomic conditions.
Hovakimian et al. (2001) find that deviation from target is an important but not dom- inant factor in explaining capital structure adjustments. The likelihood of issuing equity
is positively related to the firm’s current and immediate past stock return, and firms with a low market-to-book ratio tend to issue debt rather than equity.
In summary, the most recent literature emphasises the role of information asym- metry, equity market timing, past external funding deficits, and current debt capacity in explaining changes and the level of firm capital structure. Where firms have high information asymmetry, they access the external markets less frequently and equity mar- ket conditions are more persistent. Firms with immediate debt capacity constraints are less concerned with market timing and exhibit relatively faster debt-ratio reversion rates. Large, mature firms are more likely to conform to the pecking order theory and be less influenced by equity market timing. Finally, concern for maintaining future debt ca- pacity may result in slow levels of mean-reversion to an apparent target even though an optimal debt target does not exist.
Finally, the trade-off theory has limited empirical support in explaining short term changes in capital structure, although evidence by Kayhan & Titman (2007) suggests that the trade-off theory may hold in part over the longer term.