Mark J. Flannery
Kasturi P. Rangan
The empirical literature provides conflicting assessments about how firms choose their capital
structures. Distinguishing among the three main hypotheses (‘‘tradeoff’’, pecking order, and market
timing) requires that we know whether firms have long-run leverage targets and (if so) how quickly
they adjust toward them. Yet many previous researchers have applied empirical specifications that
fail to recognize the potential for incomplete adjustment. A more general, partial-adjustment model
of firm leverage indicates that firms do have target capital structures. The typical firm closes about
one-third of the gap between its actual and its target debt ratios each year.
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