Journal of Financial and Quantitative Analysis

Research Articles

Testing Theories of Capital Structure and Estimating the Speed of Adjustment

Rongbing Huanga1 and Jay R. Rittera2

a1 Coles School of Business, Kennesaw State University, 1000 Chastain Road NW, Kennesaw, GA 30144. [email protected]

a2 Warrington College of Business Administration, University of Florida, PO Box 117168, Gainesville, FL 32611. [email protected]


This paper examines time-series patterns of external financing decisions and shows that publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. The historical values of the cost of equity capital have long-lasting effects on firms’ capital structures through their influence on firms’ historical financing decisions. We also introduce a new econometric technique to deal with biases in estimates of the speed of adjustment toward target leverage. We find that firms adjust toward target leverage at a moderate speed, with a half-life of 3.7 years for book leverage, even after controlling for the traditional determinants of capital structure and firm fixed effects.


We thank Chunrong Ai, Harry DeAngelo, Ralf Elsas, Kristine Hankins, Steve Huddart, Marcin Kacperczyk, Jason Karceski, Robert Kieschnick, Paul Malatesta (the editor), Andy Naranjo, M. Nimalendran, Gabriel Ramirez, Kasturi Rangan, Michael Roberts, René Stulz, Jeffrey Wurgler, Donghang Zhang, and especially Mark Flannery and Ivo Welch, and seminar participants at the University of Florida, Kennesaw State University, the University of Michigan, NTU (Singapore), the 2004 All-Georgia Finance Conference at the Federal Reserve Bank of Atlanta, the October 2004 Notre Dame Behavioral Finance Conference, the 2005 Western Finance Association Conference, and the 2005 Financial Management Association Conference, as well as two anonymous referees for useful comments. We also thank Vidhan Goyal, Kamil Tahmiscioglu, and Richard Warr for kind programming assistance and Xiao Huang for help with econometrics. This paper is based on Rongbing Huang’s 2004 University of Florida doctoral dissertation. Earlier versions of this paper were circulated under the title “Testing the Market Timing Theory of Capital Structure,” but most of the analysis on the speed of adjustment (Section V) was added subsequently.