Asymmetric Capital Structure Adjustments: New Evidence from a Dynamic Panel Threshold Model

This paper proposes a novel empirical approach, called the dynamic threshold panel-data model of leverage, to testing the validity of the dynamic trade-off theory, allowing for asymmetric and costly capital structure adjustments. This approach enables us to consistently estimate the asymmetric adjustment speeds in two regimes, each of which is associated with a differential adjustment cost. We examine several proxies for adjustment costs, financial flexibility and financial constraints that affect capital structure adjustment. Using an unbalanced panel of U.K. firms between 1996-2003, we find that firms deviating considerably away from the target leverage undertake slower adjustment, low-growth firms adjust more quickly, and internal financial constraints, measured by the dividend payout ratio and firm investment, significantly reduce the speed of adjustment. Overall, the paper documents strong evidence in favor of a positive relationship between leverage and the speed of adjustment, suggesting that highly leveraged firms undertake quicker adjustment to reduce potentially high bankruptcy and liquidation costs, a finding consistent with the dynamic trade-off theory of capital structure.

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