On the Persistence of Capital Structure - Reinterpreting What We Know

38 Pages Posted: 4 Mar 2008

See all articles by Yexiao Xu

Yexiao Xu

University of Texas at Dallas - School of Management

Nina Baranchuk

University of Texas at Dallas - Naveen Jindal School of Management

Multiple version iconThere are 3 versions of this paper

Abstract

Current literature has suggested that many factors affect a firm's capital structure decision and firms do not change their capital structure very often. Such a "stable" structure has prompted Lemmon, Roberts, and Zender (2007) to advocate the use of firm fixed effect in capital structure regressions. They have shown that firm fixed effect not only explains 60% of cross-sectional variation in leverage, but also crowds out all the known explanatory variables for capital structure. In this paper, we demonstrate that the popular pooled regression approach is less biased than the fixed effect model in explaining the cross-sectional variation in leverage. In other words, the crowding out phenomenon itself actually implies that the existing literature offers useful factors in understanding the capital structures dispersion. This is confirmed in our empirical study, where we find that up to 25% of the variations in the long-term mean can be explained by the known factors. Therefore, given the persistence of capital structure, we argue that it is more important to focus our attention on what determines the dynamics of capital structure. When modeling individual firms' leverage as following an AR(1) process, we find that both persistence and shocks to capital structure are related to a number of firm characteristics. We also find that long-term means and persistence parameters change with business cycles. Our approach to capital structure also allows us to achieve better out-of-sample predictions for leverage.

Keywords: Capital Structure, Fixed Effect, Leverage, Persistence

Suggested Citation

Xu, Yexiao and Baranchuk, Nina, On the Persistence of Capital Structure - Reinterpreting What We Know. UBC Winter Finance Conference 2008 Paper, Available at SSRN: https://ssrn.com/abstract=1101206 or http://dx.doi.org/10.2139/ssrn.1101206

Yexiao Xu

University of Texas at Dallas - School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-6703 (Phone)

HOME PAGE: http://www.utdallas.edu/~yexiaoxu

Nina Baranchuk (Contact Author)

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

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