Do firms have target leverage ratios?
We examine whether firms pursue an optimum leverage ratio, what factors affect optimum leverage, and how fast firms converge towards the optimum
In 2001, John Graham and Campbell Harvey ran a survey, in which they asked 392 CFOs whether they had a target debt-equity ratio for their firm. The answer was an overwhelming “Yes”! About 71% percent of the CFOs answered that they had either a strict or a flexible leverage target (Figure 1).
71% percent of the CFOs have either a strict or a flexible leverage target
The survey addressed one of the most hotly debated topics in corporate finance, that of whether firms have an optimal capital structure. In this article, we review the evidence on this topic and hopefully we will be able to reach some conclusions that go beyond simple survey evidence.
Before we get going, it is worth highlighting another interesting piece of evidence (Figure2). Firms with high leverage ratios in one year tend to reduce debt in the following year. And, vice versa, firms with low leverage ratios in one year tend to increase debt in the following year. That is to say, firms do not seem to like very low or very high leverage ratios.
This evidence raises several questions. Why do firms move away from extreme leverage ratios? How do they end up with such extreme leverage ratios? How long does it take a firm to revert to what is considered a desirable leverage ratio?
Why should we expect firms to have a leverage target?
We are back to the trade-off theory of capital structure. This theory focuses on the benefits and costs associated with the use of debt finance. Debt finance has the advantage that interest expenses are tax deductible and give rise to a tax shield. However, debt finance can lead to bankruptcy. The value of a leveraged firm can be written as:
The trade-off theory of capital structure points towards the existence of an optimum leverage ratio. The optimum is found at the point where the marginal benefit from the tax shields is equal to the marginal cost of bankruptcy. If this point can be uniquely identified, the firm has a target leverage ratio. It is called target, because that is where the firm wants to go. And at that point, the value of the leveraged firm is maximized.
The trade-off theory of capital structure points towards the existence of an optimum leverage ratio.
The problem here is that the target is unobservable. So, we need to estimate it, if we want to investigate whether firms seek to achieve it. Which raises the question: how do we estimate the target leverage?
Estimating the target
We will focus on market leverage targets, rather than book leverage ones. Define market leverage as:
where Di,t denotes the book value of firm i’s interest-bearing debt at time t, Si,t equals the number of common shares outstanding at time t, and Pi,t denotes the price per share at time t.
Define target leverage as:
where MDR*i,t+1 is firm i’s desired debt ratio at t+1, Xi,t is a vector of firm characteristics related to the costs and benefits of operating with various leverage ratios, and beta is a coefficient vector.
The question is: which firm level variables predict target leverage? We suggest a few variables that could enter vector “X”. The list below is by no means exhaustive, and while it is restricted to firm level variables, X could include also market/economy wide variables.
• Profitability (EBIT_TA) = operating profits over total assets: More profitable firms can afford higher leverage.
• Market to book = the ratio of equity at market value + debt over equity at book value + debt: Firms with higher market-to-book ratios have a high ratio of growth options versus assets in place. They can sustain lower levels of leverage.
• Depreciation (DEP_TA) = the ratio of depreciation over total assets: Depreciation creates a tax shield like interest expenses. Firms with high depreciation assign a lower marginal value to the interest tax shield. These firms need less debt.
• Firm Size (lnTA): Larger firms are more transparent, with more stable profits, better governance, with lower financing frictions. Larger firms can support higher leverage.
• R&D expenses: Firms with high R&D expenses tend to have a high ratio of growth options. These firms can sustain lower levels of debt.
The next step is to define a model of how firms adjust their leverage towards the target. A good model for this purpose is one that looks at the change in leverage as a function of the distance from target leverage. The idea is the following: it is January,1st and the firm has a certain leverage ratio (say 50%), but it wants to lower it down (say to 30%). The distance from the target is then 20%. By how much does the firm lower leverage during this year? The full 20% or less?
A model of this kind is generally known as a partial adjustment model of capital structure. It is dynamic in nature:
The left-hand side of the equation represents the change in leverage from year t to year t+1. The terms in brackets on right-hand side of the equation represent the difference between target leverage for year t+1 and leverage in year t.
Lambda is a percentage and it captures the speed of adjustment towards the target. Each year, the typical firm closes a portion lambda of the gap between its current leverage and its target. If lambda is = 1, the firm adjusts to target in one year. If lambda is <1, the firm does not fully reach its target in one year.
The above equation can be estimated in the data. From the estimation we obtain a prediction for the target for each firm in each year. This also gives us the distance that each firm has from its desired leverage ratio. We can then sort firms according to their distance from the target and examine the change in leverage in the following year.
This exercise is carried out in Figure 3. The figure shows that firms that are over-leveraged, meaning that their leverage is above the target, tend to decrease leverage in the following year. Instead, firms that are under-leveraged, meaning that their leverage is below the target, tend to increase leverage in the following year. This evidence is very important, because it shows that firms converge towards a target, which implicitly confirms that a leverage target exists!
How fast do firms adjust to the target?
Now that we have an estimate for each target, can we predict how long it takes for the average firm to reach it? It turns out that the average adjustment speed is around 36-38% per year. This estimate implies that the typical firm closes half of the leverage gap in about 18 months.
the typical firm closes half of the leverage gap in about 18 months
Notice that the target changes not only from firm to firm, but also from year to year for each firm. This means that at a speed that is below 100%, a firm may never reach its target. As the target keeps moving, and the firm keeps adjusting only partially, the chase to the target could be a never-ending endeavour. Ultimately, it depends on how fast the target moves with respects to the adjustment speed.
The big question is: why does it take so long for a firm to reach its target? There must be some frictions that prevent CFOs to change leverage so to instantaneously position the firm at its optimum capital structure. What are these frictions? It is easy to think of different types of costs associated with retiring and issuing securities. What is the nature of these costs? Are they variable? Are they fixed? Are they of administrative or contractual nature?
All these questions require a long discussion that is beyond the scope of this article. For now, let’s say that the evidence points at the existence of adjustment costs that prevent firms from reaching their targets in the space of one year.
Conclusions
The issue of whether firms have a target capital structure has been debated for a long time. It is an important issue, because it helps us understand whether a firm has an imbalanced capital structure. Is it excessively leveraged? Or excessively financed with equity? Excessively with respect to what?
The evidence in the data indicates that firms have a desired leverage ratio
The evidence in the data indicates that firms have a desired leverage ratio, and that firms that are above that ratio tend to decrease leverage, while the opposite occurs for firms that are below target.
Estimating the target is a non-obvious exercise. In this article, we have followed the empirical literature in corporate finance, which uses a bunch of firm specific accounting and market-based variables to predict the target leverage ratio. This ratio may change from year to year, and because firms are slow at adjusting, they may never reach their target.
How is this story relevant for investing? If you can estimate what a firm’s target is, then you can predict what its change in leverage will be in the next future. This sounds like something potentially of value…
Essential Bibliography
Fama, E.F. and French, K.R., 2002. Testing trade-off and pecking order predictions about dividends and debt. The Review of Financial Studies, 15(1), pp.1-33.
Flannery, M.J. and Hankins, K.W., 2013. Estimating dynamic panel models in corporate finance. Journal of Corporate Finance, 19, pp.1-19.
Flannery, M.J. and Rangan, K.P., 2006. Partial adjustment toward target capital structures. Journal of Financial Economics, 79(3), pp.469-506.
Graham, J.R. and Harvey, C.R., 2001. The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), pp.187-243.
Leary, M.T. and Roberts, M.R., 2005. Do firms rebalance their capital structures?. The Journal of Finance, 60(6), pp.2575-2619.
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