Abstract
Several recent empirical studies in the capital structure literature challenge the traditional trade-off theory. Specifically, these studies document that historical market-to-book and past returns can explain cross-sectional leverage. These findings seem to be inconsistent with the existence of a target leverage ratio. In this paper, I show that the historical variables obtain their explanatory power from time-varying target leverage ratios and adjustment costs. The results are more consistent with a dynamic trade-off theory with adjustment costs.
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