Capital Structure Deviation and Speed of Adjustment

DOIhttp://doi.org/10.1111/fire.12017
Date01 November 2013
Published date01 November 2013
The Financial Review 48 (2013) 597–615
Capital Structure Deviation and Speed of
Adjustment
Tarun Mukherjee
University of New Orleans
Wei Wa ng
University of New Orleans
Abstract
As a firm deviates from its target leverage from above (below), the bankruptcy costs
(foregone tax savings)rise at an increasing rate while the tax savings (reduced bankruptcy costs)
rise at a decreasing rate, generating a stronger incentive for rebalancing capital structure. This
phenomenon renders the speed of adjustment (SOA) an increasing function of the deviation.
Employing a bootstrapping-based estimation strategy that avertswell-known estimation biases,
we find U.S. firms exhibit a positive SOA sensitivity to leverage deviation. Also, the SOA
sensitivity is greater for overlevered than underlevered firms.
Keywords: capital structure, speed of adjustment, adjustment costs, heterogeneity,
bootstrapping
JEL Classification:G32
Corresponding author: Universityof New Orleans, 2000 Lakeshore Dr, New Orleans, LA 70148; Phone:
(504) 280-7146; Fax: (504) 280-6397; E-mail: tmukherj@uno.edu.
Our paper has greatly benefited from the valuable comments and suggestions of Ivo Welch, Peter Iliev,
Bonnie Van Ness (the editor), and two anonymous reviewers. We also thank discussants and seminar
participants at the 2012 Southwestern Finance Association conference—“Best Paperin Corporate Finance”
(NewOrleans), the 2012 Midwest Finance Association 2012 Conference (New Orleans), the 2012 Financial
Management Association Asian conference (Phuket, Thailand), and the 2012 Financial Management
Association conference (Atlanta) for their comments. All errors are ours.
C2013The Eastern Finance Association 597
598 T. Mukherjee and W. Wang/The Financial Review48 (2013) 597–615
1. Introduction
According to the tradeoff theory, capital structure decisions involve considera-
tions of a tradeoff primarily between debt-incurred tax shield and bankruptcy costs.
A firm’s optimal (target)capital structure is where the marginal tax shield from lever-
age equals its marginal bankruptcy costs, and a deviation from the target represents
a loss in firm value. In the presence of costs associated with security issuance and
repurchase, however,a firm will act to eliminate the deviation if and when the net ben-
efit of adjustment is greater than the costs (e.g., Fischer, Heinkel and Zechner, 1989;
Strebulaev,2007). Thus, adjustment costs could hold back a firm from rebalancing its
capital structure, as evidenced by the preponderance of empirical evidence showing
on average a slow adjustment process.1Since potential for cross-firm differences in
adjustment costs and benefits exists, heterogeneous SOAs are likely results.
A small but growing strand of the capital structure literature examines the effect
of adjustment costs on a firm’s SOA. They typically instrument adjustment costs
with certain firm characteristics like firm size and report a negative relation between
adjustment costs and SOA. For example, Jalilvandand Harris (1984) show that larger
firms adjust faster than small ones. Byoun (2008) finds overlevered (underlevered)
firms rebalance more actively when they are faced with a financial surplus (deficit).
A potential explanation, albeit not explicitly made in his paper due to its focus, is
that the financial surplus saves the firm a special trip to the capital market and hence
lowers the costs of reducing leverage. Faulkender, Flannery, Hankins and Smith
(2012) (hereafter referred to as FFHS 2012) extend this probe to argue that large cash
flow realizations will lower leverage adjustment costs and induce faster adjustments.
Empirically, they find a positive relation between the magnitude of cash flows and
SOA. Lockhart (2010) shows that access to credit lines is associated with notably
faster SOA, again due to the lower adjustment costs. Oztekin and Flannery (2012)
conduct a cross-country study to confirm the link between SOAs and proxies of
adjustment costs.
Our paper differs from the literature discussed above in that it emphasizes the
linkage between adjustment benefit and adjustment speed. In particular, we posit
that a firm’s SOA positively depends on the deviation from its target leverage. The
rationale rests on the discrepant rates at which the tax shield and bankruptcy costs
change as the leverage deviation increases. Abstracting from progressive tax rates,
the expected tax shield is a concave function of the use of debt, increasing at a
decelerating rate which eventually turns negative, as the likelihood of using the full
extent of the tax shield offered by debt diminishes with leverage. In contrast, the
1The speed of adjustment (SOA) estimates range from 7% to 10% in Fama and French (2002) to 36%
in Flannery and Rangan (2006), corresponding to half-lives of leverage deviation from 1.6 years to 9.6
years. In the same vein, Leary and Roberts (2005) conclude that firms undo leverage shocks in a slowand
intermittent fashion via equity and debt issuance activities. The partial adjustment phenomenon echoes
the survey results of Graham and Harvey( 2001)that most firms claim to have capital structure targets, but
achieving the target is not always of prime urgency,and both are consistent with the tradeoff theory.

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