| Both theory and practice seem to agree that firms adjust their capital structure to stay in close proximity to a target leverage ratio. However, this target leverage ratio is not accounted for as a determinant of leverage in existing empirical work. Recent findings in the leverage adjustment speed literature yield a practical way to calculate these target leverage ratios. In this paper, I calculate the deviation of actual leverage from target leverage and use it as a determinant of firm's leverage along with a set of other control variables that are traditionally used in the literature. I find that the addition of deviations from target leverage more than doubles the explanatory power compared to existing empirical specifications. Using standardized regression coefficients I show that the deviation from target leverage ratios is the most important determinant of firms' capital structure. |
