The Benefits of Adjusting - Estimating the Speed of Adjustment toward a Target Capital Structure on a Cost Basis

Abstract

I estimate the speed of adjustment toward a target capital structure on a cost basis. Whereas other papers test for mean reversion of leverage ratios, I test for mean reversion in the opportunity cost of being away from a target capital structure. The primary benefit of this approach is that the opportunity cost provides a direct link between changes in capital structure and changes in firm value and allows me to quantify the economic benefit of a given speed of adjustment policy as a percent of firm value. The mean firm saves about 3.3% of total assets by following the estimated speed of adjustment policy of 47.3% vis-a-vis a random financing policy. However, firms would not realize any significant gain (less than 0.40% to total assets) by changing their policy from the observed to a policy of complete adjustment. As such, firms appear to be not only adjusting toward optimal capital structures in a meaningful way but also optimizing the speed at which they adjust.