Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure

We find that the majority of variation in leverage ratios is driven by an unobserved timeinvariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. This feature of leverage is largely unexplained by previously identified determinants, is robust to firm exit, and is present prior to the IPO, suggesting that variation in capital structures is primarily determined by factors that remain stable for long periods of time. We then show that these results have important implications for empirical analysis attempting to understand capital structure heterogeneity. Eccles School of Business, University of Utah; The Wharton School, University of Pennsylvania, and Leeds School of Business, University of Colorado. We are especially grateful for helpful comments from our referee and associate editor. We also thank Franklin Allen, Heitor Almeida, Yakov Amihud, Lincoln Berger, Alon Brav, Mark Flannery, Murray Frank, Sara Ghafurian, William Goetzmann, Vidhan Goyal, John Graham, Mark Leary, Andrew Metrick, Roni Michaely, Vinay Nair, Darius Palia, Mitchell Petersen, Rob Stambaugh, Ivo Welch, Toni Whited, Bilge Yilmaz; seminar participants at University of Arizona, Babson College, Boston College, Cornell University, Drexel University, Harvard University, University of Colorado, University of Maryland, University of Michigan, University of North Carolina, University of Pennsylvania, Queens University, the University of Western Ontario; and conference participants at the 2005 Five-Star Conference, 2005 Hong Kong University of Science and Technology Finance Symposium, 2006 NBER Corporate Finance Conference, and 2006 Western Finance Association for helpful discussions. Roberts gratefully acknowledges financial support from a Rodney L. White Grant and an NYSE Research Fellowship. A fundamental question in financial economics is: How do firms choose their capital structures? Indeed, this question is at the heart of the “capital structure puzzle” put forward by Myers (1984) in his AFA presidential address. Attempts to answer this question have generated a great deal of discussion in the finance literature. Many studies, both before and after Myers’ pronouncement, identify a number of factors that purport to explain variation in corporate capital structures. However, after decades of research, how much do we really know? More precisely, how much closer have previously identified determinants and existing empirical models moved us toward solving the capital structure puzzle? And, given this progress, how can we move still closer to ultimately providing a more complete understanding of capital structure decisions? The goal of this paper is to address these questions. Specifically, we quantify the extent to which existing determinants govern cross-sectional and time-series variation in observed capital structures by examining the evolution of corporate leverage ratios. In doing so, we are not only able to assess the progress of existing empirical work, but more importantly, we are also able to characterize what existing determinants appear to miss – the gap in our understanding of what determines heterogeneity in capital structure. Our analysis, while shedding light on several issues, also presents some new challenges to understanding how firms choose their capital structures. We begin by showing that leverage ratios exhibit two prominent features that are unexplained by previously identified determinants (e.g., size, profitability, market-tobook, industry, etc.) or changes in sample composition (e.g., firm exit). These features are illustrated in Figure 1 (see Section II), which shows the future evolution of leverage ratios for four portfolios constructed by sorting firms according to their current leverage