Dynamic Capital Structure Choice: Theory and Tests

TLDR

The paper develops a model of dynamic capital structure choice that incorporates recapitalization costs. The authors derive an optimal dynamic recapitalization policy based on firm characteristics and use a firm’s debt‑ratio range as an empirical measure of capital‑structure relevance. Empirical tests show that modest recapitalization costs cause large debt‑ratio swings and that firms’ debt‑ratio ranges correlate with firm characteristics, supporting the dynamic capital‑structure model.

Abstract

ABSTRACT This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm‐specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm‐specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.