Testing the Trade-Off Theory of Capital Structure: A Kalman Filter Approach

Abstract

In this paper, we use a Kalman filter in order to test the standard dynamic trade-off model of capital structure. In this model, the observed realized debt-equity ratio is a weighted average of the unobservable target debt-equity ratio and last period's realized debt-equity ratio. The use of the Kalman filter, however, allows us to directly estimate the unobservable target debt-equity ratio. We find that the trade-off model cannot be rejected for 32% to 52% of the firms in our sample at the standard 5% level. We also use a regression in order to test if our Kalman filter estimated target debt-equity ratios are related to the fundamental variables usually proposed in the corporate structure literature. Overall, we find support for our estimates.