A critical assessment of the partial leverage adjustment model: Target-overshooting behavior

Abstract

More than 30 percent of Compustat firms overshoot target leverage within one to two years, contrary to the partial leverage adjustment model’s (PLAM) central tenet of incremental adjustments year by year. Because overshooting involves large adjustments, the presence of overshooting firms can skew researchers’ inferences drawn from the PLAM. This study reveals that if we remove overshooting firms from the dataset, the estimated leverage-adjustment speed is much lower and, more importantly, the average firm stops moving toward the target well before the halfway point. Ironically, the conclusion of firms’ partial and steady movements toward target leverage in the PLAM research looks like a statistical artifact arising from the preponderance of overshooting.