External Cost of Leverage Adjustment: Evidence from Defined Benefit Pension Plans

Abstract

This paper investigates the influence of external cost shock on the speed of adjustment (SOA) toward target capital structure. To look at the impact of an exogenous shock on the speed of adjustment, we employ mandatory contributions (MCs) of defined benefit (DB) pension plans as a measure of the external shock, and find a significant impact of MCs on SOA toward target leverage. This impact of MCs on SOA is negative and more significant for over-levered firms, whereas it is positive but less significant for under-levered firms. This result demonstrates that firms, especially over-levered firms, adjust to their target leverage actively rather than passively. Additionally, we show that this impact of MCs on SOA is heterogeneously determined for the firms with different levels of leverage volatility and managerial entrenchment. Our results are robust when using system GMM estimation to reduce the bias in estimation.

Keywords: defined benefit pension plans; mandatory contributions; dynamic capital structure; speed of adjustment; target leverage

JEL Classification: G23; G30; G32