Capital Structure Dynamics: Near vs. Off Target Firms in Sri Lanka

S Buvanendra

doi:10.4038/cbj.v8i1.13

Abstract

This research paper aims at examining the determinants of the Speed of Adjustment (SOA) towards the target capital structure of near and off target firms in Sri Lanka. Particularly, it analyses the impact of not only firm-specific factors but also corporate governance factors on target capital structure. The methodology utilizes the benefits of the partial (stock) adjustment model, viz, two step Generalised Method of Moments (GMM) to determine the SOA to target capital structure. The results indicate that there is discernible concrete evidence of dynamic behaviour of capital structure in Sri Lanka. This confirms the applicability of dynamic trade-off theory. The near or off target firms’ capital structure adjustment exhibits significant difference in SOA between the two types, implying that off target firms adapt swiftly vis-à-vis those at the doorstep of target firms, in each of the three models. There is a clear indication of both firm related factors and corporate governance factors swaying capital structure adjustment in at least one of the measures of leverage in both situations, very near to and far off from optimum level of debt.

Highlights

Capital structure is winning escalating contemplation by the researchers in corporate financial management
Unlike previous research on capital structure, this study focuses on identifying which factors affect speed of adjustment towards target capital structure, while comparing near and off target firms as well as adjusted for the panel nature of the data
The sample is divided into two subsamples, based on the deviation of actual debt ratios from the target (i.e. Lev*i,t - Levi,t-1) regardless of the direction of the deviation. It is created based on 50th percentile as cut off point. Thereafter, it is grouped as firms below the median as ‘near target firms’ and above the median as ‘off target firms’

Summary

Introduction

Capital structure is winning escalating contemplation by the researchers in corporate financial management. Modigliani-Miller theorem (MM), resulting in a variety of theories including the trade-off theory and the pecking order theory (Myers, 1984; Myers & Majluf, 1984). Jensen and Meckling, developed the theory on agency cost in 1976. This tackles the principal- agent and principal – principal predicament of corporate governance of capital structure. Research on capital structure has moved from the theories prevalent to exploration of determinants of the capital structure in a wider scenario (see Baker & Wurgler, 2002; Malmendier, Tate, & Yan, 2005; Welch, 2004)

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