Back to the Beginning : Persistence and the Cross-Section of Corporate Capital Structure

We examine the evolution of the cross-sectional distribution of capital structure and find that leverage is remarkably stable over time; firms with high (low) leverage today remain relatively highly (low) levered for over 20 years. Additionally, this relative ranking is largely unaffected by the process of going public and is observed for both public and private firms. These persistent differences in leverage across firms are associated with the presence of an unobserved firm specific effect that is responsible for the majority of variation in capital structure. Over 90% of the explained variation in leverage is captured by these firm fixed effects, whereas previously identified determinants (e.g., size, marketto-book, industry) are responsible for less than 10%. Our findings show that firms use their financial policies to maintain their leverage ratios in relatively confined regions around their long run means, consistent with costly adjustment in a dynamic tradeoff framework. Importantly, our results imply that the primary determinant of cross-sectional variation in corporate capital structures is largely time invariant and, therefore, significantly reduces the set of candidate explanations to those based on factors remaining relatively stable over long periods of time. A fundamental challenge for corporate finance lies in understanding the determinants of capital structure. To this end, recent research has examined the dynamic behavior of leverage ratios in order to distinguish among competing explanations for the observed heterogeneity in capital structures. Several studies have focused on how firms respond to various shocks affecting capital structure (e.g., Alti (2005), Flannery and Rangan (2005), Leary and Roberts (2005) and Strebulaev (2004)), while others have focused on how historical factors affect current capital structure (e.g. Baker and Wurgler (2002), Welch (2004), and Kayhan and Titman (2005)). In this study we take a somewhat broader approach, examining the evolution of the cross-sectional distribution of leverage ratios and analyzing the implications of our findings for various theories of capital structure, as well as previous empirical findings. Our analysis, while shedding light on several issues, also presents some new challenges to our understanding of capital structure. We begin by showing that leverage is remarkably stable over time. This fact is illustrated in Figure 1 which, despite showing significant convergence over time, illustrates that firms with relatively high (low) leverage at time t tend to maintain high (low) leverage for over 20 years. Moreover, these differences in leverage ratios are statistically and economically large, and cannot be explained by differences in previously identified determinants (e.g., size, profitability, market-to-book, industry, etc.) or firm entry and exit. The magnitude of these differences is quantified by regression analysis identifying firms’ initial leverage ratios as the single most important determinant of future capital structure. Simply put, firms tend to maintain their relative rankings – in terms of leverage ratios – for a very long time. These results suggest that corporate capital structures are characterized by an important firm specific effect. How important? The adjusted R-square from a regression of leverage on firm fixed effects alone is 60%, implying that the majority of variation in capital structure is time invariant. This is in contrast to the adjusted R-square from a similar regression of investment on firm fixed effects: 35%. This is also in contrast to the adjusted R-squares from traditional leverage regressions consisting of previously identified determinants (e.g., size, market-to-book, profitability, industry, etc.). Depending on the specification, these R-squares range from 16% to 30%. Moreover, we show that existing determinants are highly correlated with the firm specific effect. When we incorporate firm fixed effects into traditional specifications, a variance decomposition reveals that over 90% of the explained sum of squares is attributable to the fixed effects, with the remaining percentage accounted for by traditional determinants. We then investigate the implications of these findings for existing empirical evidence, as well as theories of capital structure. First, the estimated association between leverage and previously identified determinants is very sensitive to the inclusion of firm specific effects. Most coefficient estimates experience a decrease in magnitude exceeding 40% and, in some cases (e.g., market-to-book, dummy for dividend paying firms) lose all statistical significance. However, other estimates (e.g., firm size, cash flow volatility) experience an increase in magnitude of over 300% as a result of introducing firm specific effects. Given the importance of firm specific heterogeneity in leverage, as well as other aspects of the firm (e.g, investment and production), parameter estimates ignoring this dimension of the data are suspect.