– The purpose of this paper is to investigate the phenomena of convergence and stability of leverage reported by Lemmon et al. (2008).
Abstract
Purpose
The purpose of this paper is to investigate the phenomena of convergence and stability of leverage reported by Lemmon et al. (2008).
Design/methodology/approach
A dynamic trade-off model of the firm was used to simulate investment, leverage, and payout decisions for different types of firms. From an econometric standpoint, the Efficient Method of Moments was used to recover the structural parameters.
Findings
The structural model generates a leverage ratio that oscillates around a long-run, time-invariant level and consistently reproduces the convergence and stability of leverage reported by Lemmon et al. (2008). The model also suggests the causes of those observed properties of the data. That is, convergence is due to the mean-reversion of profits while stability is due to the different fundamental characteristics (e.g. capital elasticity, volatility of profits, etc.) of the firm.
Practical implications
Determining the optimal capital structure of a firm is a complex problem that has challenged academics and practitioners for a long time. Understanding leverage decisions is of great importance not only for financial managers, but also for investors, such as banks, debt-holders, equity-holders, and other capital providers, who need to understand how firms make capital structure decisions in order to achieve an efficient allocation of funds.
Originality/value
The author shows that the firm-specific fixed effects in leverage regressions are not related to the usual determinants (e.g. profitability, market-to-book ratio), but to the primitive characteristics of the firm (e.g. elasticity of capital in the production function, the volatility of profits, the capital depreciation rate, the income tax rate, etc.)