Fundamentals and the Persistence and Convergence in Corporate Capital Structure

Recent research shows that the persistent cross-sectional pattern for leverage ratios is largely initially determined by both observed and unobserved firm characteristics; despite this persistence, some convergence occurs in leverage ratios. While these findings call for rethinking capital structure, the literature has not yet provided much insight into how firm fundamentals affect leverage ratio evolutions. If leverage ratios are quite persistent, can changes in firm characteristics such as market-to-book ratios and asset tangibility affect them, and if so, how? These changes in leverage determinants may be too small. Even if the changes are considerable, the responses of corporate capital structure may be time varying—in other words, the determination structure (parameters) may change—so as to buffer the changes in leverage determinants, which the researchers know are most relevant to the cross-sectional variation in capital structure. To address these issues, this project attempts to decompose leverage ratio changes into:changes in observed leverage determinants;changes in the leverage determination structure (parameters); andchanges in unexplained elements.This decomposition can shed light on the fundamental determination of both the cross-sectional and time variations in corporate capital structure.