PartialAdjustmentTheoryofCapitalStructure.docVIP

Testing the Trade-off Theory of Capital Structure: A Kalman Filter Approach Tian Zhao Invesco Aim Capital Management LLC Department of Investment, Houston, TX 77046 (713) 214-1631 Tian.Zhao@ And Raul Susmel Department of Finance C.T. Bauer College of Business University of Houston Houston, TX 77204 (713) 743-4763 rsusmel@ September 2008 Abstract In this paper, we use a Kalman filter in order to test the standard dynamic trade-off model of capital structure. In this model, the observed realized debt-equity ratio is a weighted average of the unobservable target debt-equity ratio and last period’s realized debt-equity ratio. The use of the Kalman filter, however, allows us to directly estimate the unobservable target debt-equity ratio. We find that the trade-off model cannot be rejected for 32% to 52% of the firms in our sample at the standard 5% level. We also use a regression in order to test if our Kalman filter estimated target debt-equity ratios are related to the fundamental variables usually proposed in the corporate structure literature. Overall, we find support for our estimates. Keywords: Dynamic trade-off theory, Kalman filter JEL Classification: G32, C51. * We thank Ronald Singer and Ramon Rabinovitch for their insightful suggestions and advice. We also thank Abu Amin for a series of helpful discussions.  Testing the Trade-off Theory of Capital Structure: A Kalman Filter Approach September 2008 Abstract In this paper, we use a Kalman filter in order to test the standard dynamic trade-off model of capital structure. In this model, the observed realized debt-equity ratio is a weighted average of the unobservable target debt-equity ratio and last period’s realized debt-equity ratio. The use of the Kalman filter, however, allows us to directly estimate the unobservable target debt-equity ratio. We find that the trade-off model cannot be rejected for 32% to 52% of the firms in our sample at the standard 5% level. We also use a