Do Firms Have a Target Leverage? Evidence from Credit Markets

Abstract

The static tradeoff theory of capital structure hypothesizes that firms have a target leverage which optimizes firm value in the presence of benefits and costs of leverage (such as taxes and bankruptcy costs). If firms adjust their actual leverage toward this target leverage over time, then rational investors should consider both current and target leverage in pricing contracts whose value depends on the firm’s default risk. Using a large sample of corporate bonds and credit default swap (CDS) contracts during 2000 to 2007, we document evidence consistent with this prediction. In particular, target leverage is both an economically and statistically significant determinant of bond and CDS spreads, and its role increases with contract maturity. Credit ratings also reflect the effect of target leverage, which suggests that the credit rating agencies rate firms as if their capital structure decisions are consistent with the tradeoff theory.