An Empirical Target Zone Model of Dynamic Capital Structure

We develop and estimate a general (S, s) model of capital structure to investigate the relation between target leverage, refinancing thresholds, and firm characteristics in a dynamic environment. We find that firms’ target leverage is pro-cyclical, consistent with dynamic capital structure models, but in contrast to traditional regression results. The target leverage zone, in which companies optimally allow leverage to float, widens during recessions. Most of the time series variation in capital structure policy variables is due to aggregate macroeconomic factors, rather than changes in firm-specific variables.