The impact of financial flexibility and macroeconomic conditions on the adjustment speed towards optimal capital structures

Previous literature explains capital structure through the trade-off, market timing and pecking order theory. This paper provides evidence in support of the trade-off theoryby examining the determinants of the optimal leverage ratio and the adjustment speed towards this leverage ratio. It finds firms converge towards the optimal leverage ratio with aspeed between 21.9% and 33.1%per year. Additionally, it fills the gap in literatureon how the effect of financialflexibilityimpacts the speed ofadjustment.It finds a higher adjustment speed for over-levered firms and a lower speed of adjustment for under-levered firms. It explains the findings through the value of financial flexibility, which lies in not having to forego positive NPVprojects in times of limited access the capital marketsand the capabilityto overcome costs of financial distress.Lastly, it investigates the effect of macro-economic conditions on the adjustment speed and the interaction with financial flexibility. In order to test the relationships of between financial flexibility and the adjustment speed towards the optimal leverage ratio an extended version of the partial adjustment model of Flannery & Rangan, (2006) has been used. The final US dataset includes over 159,000 firm-year observations of the Compustat database.