Target Behavior and Financing: How Conclusive is the Evidence?

Abstract

The notion that firms have debt ratio targets and that this is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the available evidence? We examine this question by benchmarking the dynamics of actual debt ratios and the pattern of financing after major leverage-changing events against what is observed when samples are generated through simulations in which no target behavior is assumed. We find that the collective evidence that has been interpreted as indicative of target behavior is much weaker than is generally recognized. Specifically, the simulated data show similar reversal of the debt ratio and patterns of debt and equity issuance after major issuance activities or shocks to stock returns as in the actual data. We attribute the former to a mechanical reversal that exists on average, even with random financing, if the debt ratios are above or below a cut-off, and the latter to persistence of the financing deficit around major issuance activities. Some of the evidence in the actual data, however, can only be replicated if the simulation samples are modified to accommodate a specific type of market timing behavior. emmon, Roberts, and Zender (2006) find that differences in initial leverage ratios persist over time; remarkably, the simulated data exhibits similar persistence. Our results show that a firm-specific component in the time-series of the financing deficit and change in retained earnings contributes to this persistence. On the whole, however, our results indicate that there is not much to be learnt from the behavior of the debt ratios as to firms' motives for different types of financing.