Do Firms Rebalance Their Capital Structures?

We empirically examine whether firms engage in dynamic rebalancing of their capital structures, while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for the dynamic behavior of corporate financial policy and the interpretation of previous empirical results. Then, after confirming that financing behavior is consistent with the presence of adjustment costs, we use a dynamic duration model to show that firms behave as though adhering to a financial policy in which they actively rebalance their leverage to stay within an optimal range. We find that firms respond to changes in their equity value, due to price shocks or equity issuances, by adjusting their leverage over the two to four years following the change. The presence of adjustment costs, however, often prevents this response from occurring immediately, resulting in shocks to leverage that have a persistent effect. Our evidence suggests that this persistence is more likely a result of optimizing behavior in the presence of adjustment costs, as opposed to indifference towards capital structure.