Leverage Dynamics Under Segmented Equity and Debt Markets

Abstract

We study a continuous-time dynamic capital structure model in which a firm can continuously adjust its capital structure. Unlike previous models, we assume heterogeneous equity and debt holders and segmented equity and debt markets. We show that the expected future equity and debt market returns, but not realized market returns, affect the firm's debt issuance policy and speed of leverage adjustment. The effect is stronger for firms with larger asset beta. We empirically test and confirm our model predictions.