Journal of Financial and Quantitative Analysis

Research Articles

Equity Mispricing and Leverage Adjustment Costs

Richard S. Warra1, William B. Elliotta2, Johanna Koëter-Kanta3 and Özde Öztekina4

a1 Poole College of Management, North Carolina State University, Box 7229, Raleigh, NC 27695 rswarr@ncsu.edu

a2 Department of Economics and Finance, University of Texas at El Paso, 500 W University Ave, El Paso, TX 79968 wbelliott@utep.edu

a3 Faculty of Economics and Business Administration, VU University Amsterdam, De Boelelaan 1105, Amsterdam 1081 HV, The Netherlands Koëter-Kant, jkoeter@feweb.vu.nl

a4 College of Business Administration, Florida International University, 11200 SW 8th St, Miami, FL 33199. ozde@fiu.edu

Abstract

We find that equity mispricing impacts the speed at which firms adjust to their target leverage (TL) and does so in predictable ways depending on whether the firm is over- or underlevered. For example, firms that are above their TL and should therefore issue equity (or retire debt) adjust more rapidly toward their target when their equity is overvalued. However, when a firm is undervalued but needs to reduce leverage, the speed of adjustment is much slower. Our findings support the role of equity mispricing as an important factor that alters the cost of making capital structure adjustments.

(Online publication January 17 2012)

Footnotes

We thank Erik Devos, Srini Krishnamurthy, James Upson, Mark Walker, Baozhong Yang (the referee), and seminar participants at North Carolina State University, and the 2009 European Financial Management Association Annual Meeting for many helpful comments. All errors remain our own.

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