We examine the dynamic behavior of corporate capital structures in order to determine the empirical relevance of recent theories. We begin by showing that capital structure is highly persistent, so much so that the cross-sectional distribution of leverage in the year prior to the IPO is largely unchanged almost twenty years later. Moreover, our analysis suggests that market timing (Baker and Wurgler (2002)) and inertia (Welch (2004)) are unlikely explanations for the observed cross-sectional variation in capital structures, which exists prior to firms ’ IPOs. Rather, our results indicate that factors associated with debt policy have significant and long lasting effects on capital structure, as opposed to factors associated with equity policy. Further analysis of capital structures at the time of and prior to the IPO reveal heterogeneity in private financing decisions and debt contracts consistent with segmented capital markets. While suggestive, ultimately our results suggest a critical need for understanding variation in corporate debt policies and the determination of private firms ’ capital structures in order to better understand public firms ’ capital structures, the latter of which are largely a reflection of the former. A common theme among recent investigations into corporate capital structure is the

We show that a large number of significant financing decisions of solvent firms are dictated by creditors, who use the transfer of control accompanying financial covenant violations to address the misalignment of incentives between managers and investors. After showing that financial covenant violations occur among almost one third of all publicly listed firms, we find that creditors use the threat of accelerating the loan to reduce net debt issuing activity by over 2 % of assets per annum immediately following a covenant violation. Further, this decline is persistent in that net debt issuing activity fails to return to pre-violation levels even after two years, resulting in a gradual decline in leverage of almost 3%. These findings represent the first, of which we are aware, piece of empirical evidence highlighting the role of control rights in shaping corporate financial policies outside of bankruptcy. “[Ross] Johnson explained that he was looking for a structure in which he would retain significant control of his company…He remembered the backbreaking trips to GSW’s bankers twenty years before and cringed. Banks…cramped his style.”-Barbarians at the Gate “The Credit Facility also requires the company to meet certain financial ratios and tests. These covenants…significantly limit the operating and financial flexibility of the Company and limit its ability to respond to changes in its business…”

The notion that firms have a debt ratio target which is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the evidence? We address this issue by generating samples where financing is unrelated to a firm’s current debt ratio or a target. We find that much of the available evidence in favor of target behavior based on leverage ratio changes can be reproduced for these samples. Taken together, our findings suggest that a number of existing tests of target behavior have no power to reject alternatives.

In the context of large acquisitions, we provide evidence on whether firms have target capital structures. We examine how deviations from these targets affect how bidders choose to finance acquisitions, the valuation effects of those decisions, and how bidders adjust their capital structure following the acquisition. We find that when a bidder’s leverage is over its target level, it is less likely to finance the acquisition with debt and more likely to finance the acquisition entirely with equity. Bid announcement returns reveal that movements away from an optimal capital structure reduce firm value. Following cash acquisitions that over-lever the firm, managers actively move the firm back to its target leverage, reversing 75 % of the acquisition’s leverage effect within 5 years. Attempts to mitigate under and overinvestment problems are important determinants of bidders ’ decisions to maintain a target capital structure. Overall, our results are strongly consistent with a model of capital structure that includes a target level and adjustment costs.

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We show that the most important observable capital structure determinant for many firms is the capital structure of their peers; firms make financing decisions in large part by responding to the financing decisions of peer firms, as opposed to changes in firm-specific characteristics. We also find that smaller and less successful firms are more likely to adjust their capital structures and financial policies in response to the actions of their larger, more successful peers. Finally, we quantify the externalities engendered by peer effects, which can amplify the impact of changes in exogenous determinants on leverage by over 70%.Most research on corporate financial policy assumes capital structure choices are made independent of the actions or characteristics of their peers. In other words, a firm’s capital structure is typically assumed to be determined by a function of its marginal tax rate, expected deadweight loss in default, information environment, and incentive structure. As such, the role for peer firm behavior in affecting capital structure is often ignored, or at most an implicit one through its unmeasured impact on firm-specific determinants.

Firms in bilateral relationships are likely to produce or procure unique products – especially when they are in durable goods industries. Consistent with the arguments of Titman (1984) and Titman and Wessels (1988), such firms are likely to maintain lower leverage. We compile a database of firms ’ principal customers (those that account for at least 10 % of sales or are otherwise considered important for business) from the Business Information File of Compustat and find results consistent with the predictions of this theory.

Firms that intentionally increase leverage through substantial debt issuances do so primarily as a response to operating needs rather than a desire to make a large equity payout. Subsequent debt reductions are neither rapid, nor the result of proactive attempts to rebalance the firm’s capital structure toward a long-run target. Instead, the evolution of the firm’s leverage ratio depends primarily on whether or not the firm produces a financial surplus. In fact, firms that generate subsequent deficits tend to cover these deficits predominantly with more debt even though they exhibit leverage ratios that are well above estimated target levels. Our findings are broadly consistent with a capital structure theory in which financial flexibility, in the form of unused debt capacity, plays an important role in capital structure choices. (JEL G32) The search for an empirically viable capital structure theory has confounded financial economists for decades. Standard trade-off models of capital structure have been criticized on the grounds that they do a poor job of explaining observed debt ratios. For example, traditional trade-off models have difficulty explaining why firms tend to issue stock after exogenous decreases in leverage

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