Dynamic Model of Capital Structure

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May 2006 McCombs Research Paper Series No. FIN-03-06

A Dynamic Model of Optimal Capital Structure

Sheridan Titman
McCombs School of Business The University of Texas at Austin e-mail: titman@mail.utexas.edu

Sergey Tsyplakov
Moore School of Business The University of South Carolina, Columbia, SC

This paper also can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract/332042

A Dynamic Model of Optimal Capital Structure∗
Sheridan Titman McCombs School of Business Department of Finance University of Texas at Austin Austin, TX 78712-1179. Sergey Tsyplakov Moore School of Business Department of Finance University of South Carolina Columbia, SC 29208

Current Draft: November 2, 2005

Authors’ e-mail addresses are titman@mail.utexas.edu and sergey@moore.sc.edu respectively. Au-

thors would like to thank session participants at the 2004 Meetings of Society of Economic Dynamics, 2002 WFA meetings, 2002 SFA meetings and seminar participants at Arizona State University, Fordham University, Georgia Institute of Technology, Indiana University, Louisiana State University, McGill University, the University of British Columbia, the University of Florida, the University of Miami, the University of Nevada at Las Vegas, the University of South Carolina, the University of Texas and, especially, Andres Almazan, Jeffrey Coles, Lorenzo Garlappi, Ronen Israel, Gerald Jensen, Nengjiu Ju, David Mauer, Ted Moore and Stathis Tompaidis for their valuable comments.

A Dynamic Model of Optimal Capital Structure
Abstract This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. The model extends the dynamic capital structure literature by endogenizing the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm’s product market. Within the context of this model we explore interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the capital structure choice affects both target debt ratios and the extent to which actual debt ratios deviate from their targets. In particular, we examine how financial distress and the firm’s objectives, i.e., whether it makes choices to maximize total firm value versus equity value, influence the extent to which firms make financing choices that move them towards their target debt ratios.



The concept of a target debt ratio, which reflects the tradeoffs between the benefits and costs of debt financing, is quite familiar to most finance managers. For example, in a survey of CFOs, Graham and Harvey (2001) report that 37% of their respondents have a flexible target debt ratio, 34% have a somewhat tight target or range and 10% have a strict target. This concept also plays a central role in many theories of optimal capital structure, however, there is substantial debate about the extent to which the idea of a target debt ratio is useful. For example, a recent paper by Fama and French (2002) suggest that firms move quite slowly towards their targets, and a number of papers suggest that earnings and stock price changes lead to capital structure changes that are only slowly reversed.1 One interpretation of this evidence is that the determinants of capital structure described in the tradeoff models matter very little — in other words, the function mapping capital structure to firm values is quite flat, implying that it is not particularly costly for firms to deviate from their target capital structures. When this is true, and when significant transaction costs exist, firms will tend to move slowly towards their target debt ratios. Previous research explores the importance of transaction costs on the tendency of firms to move towards their target debt ratios2 , but have not seriously explored the costs associated...
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