Nonlinear modelling of target leverage with latent determinant variables — new evidence on the trade‐off theory

In: Review of financial economics: RFE, Band 19, Heft 4, S. 137-150

Abstract

AbstractThis paper applies a nonlinear structural equation framework to analyze dynamic capital structure choice. I test the hypothesis that firms adjust leverage towards a time‐varying target, and that this target is determined by solving an optimization problem: optimal leverage is achieved when the difference between the expected net present value of the tax shield and the expected net present value of the costs of insolvency is maximized. Results indicate that firm size is an important determinant of the validity of this simple trade‐off model.