An Empirical Investigation of Dynamic Capital Structure Theories: Evidence from Europe

Robin Maximilian Schröder & Edward Enoch Sosman

Student thesis: Master thesis


This thesis analyses capital structure dynamics in Europe based on a large sample of 1.196 firms between 2004 and 2014. It begins by mapping the four most prevalent theoretical paradigms within dynamic capital structure and points at their predictions of financing decisions of firms. The first is the inertia proposition (Welch, 2004) that claims that changes in capital structure are solely driven by equity returns. The second is the market timing theory (Baker and Wurgler, 2002) that argues that executives try to time the market by issuing equity when share prices are high. The third is the dynamic pecking order theory (e.g. Morellec and Schürhoff, 2011), which supports the notion that adverse selection is the main driver behind capital structure development. The last is the dynamic trade-off theory (e.g. Fischer, Heinkel, and Zechner, 1989) that explains capital structure policy in light of adjustment costs. Empirically it is examined whether firms allow their leverage ratio to be determined by varying equity returns or if they try to exploit the market by issuing expensive equity. Neither is found to be true. Equity returns only have temporary effects on the leverage ratio and companies rebalance their capital structure within 2 to 5 years subsequent to an equity shock. While it is true that firms that issue equity for five years have a lower leverage ratio than firms that do not, only weakly significant evidence of market timing attempts of European firms has been found. When timing the capital markets European firms rely more on debt than on equity, which contradicts conclusions from previous research on the US market. This can possibly be attributed to structural changes in European capital markets during the investigated time period. It is found that the persistence of equity shocks and market timing attempts on leverage is more likely due to adjustment costs and therefore strong evidence for the trade-off theory is found. Further, a (S, s) model of capital structure is developed that investigates the relationship between firm and macro characteristics and leverage target and range in a multi-period setting. Among the firm characteristics the MB ratio, firm size, asset tangibility and profitability are found to have the largest impact on capital structure dynamics in Europe. Among the macroeconomic variables the term structure is found to have a positive effect on target leverage and the leverage boundaries. This implies that companies tend to lever up or allow high leverage levels in times in which the economic prospects are promising.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2016
Number of pages127