The dynamics of corporate leverage in Europe

: speed of adjustment across macroeconomic states

Abstract

Incorporating economic fluctuations into dynamic capital structure has proven to be predominantly relevant for understanding how these can influence firms’ debt-equity choice. Recent events such as the Global Financial Crisis, the Eurozone Sovereign Debt Crisis, and the COVID-19 pandemic contributed to intensify volatility in equity markets, government bond yields and inflation, reinforcing the need to consider variations in macroeconomic states when determining firms’ optimal leverage. Recent literature highlights that firms set leverage targets, to which managers realign debt-levels back at different paces, in response to macroeconomic conditions. This paper estimates the speed of adjustment (SOA) towards a target leverage for European firms across 25 countries from 2000 to 2022. Utilizing book and market debt ratios, the sample is divided into different economic states based on GDP growth, term spread, and inflation rate. Through an integrated partial-adjustment model, this study finds that European firms adjust their book-valued ratios faster compared with their market-leverage ratios. The outcomes also indicate that, when using market debt ratios, firms adjust faster during economic expansions marked by GDP growth. Accounting for the potential zero-leverage firms bias, this effect extends to the book-valued sample. The study also reveals that, with market-valued leverage, the SOA was slower during the Global Financial Crisis. Conversely, firms adjusted faster towards their target when employing book debt ratios during the COVID-19 pandemic. Additionally, a two-stage model, incorporating a quasi-maximum likelihood estimation method to determine the target leverage, suggests that, when using book debt ratios, firms adjust faster under inflationary pressure.

Date of Award	23 Jan 2024
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Diana Bonfim (Supervisor)