We identify a powerful and reliable empirical test of the tradeoff theory based on the nested logit model. Applying the nested logit model, we address the important issue of whether external cash flow consideration or leverage adjustment consideration is of first order importance to firms. We find that when firms are near the target debt ratios, external cash flow consideration seems to be more important, and when firms are far away from the target, leverage adjustment consideration seems to be more relevant. The result is consistent with Leary and Roberts’ notion of soft target. We also find evidence consistent with the extant literature that firms adjust their capital structures mainly through repurchase activities, and equity market timing plays a more important role in issuance acti...[ Read more ]

We identify a powerful and reliable empirical test of the tradeoff theory based on the nested logit model. Applying the nested logit model, we address the important issue of whether external cash flow consideration or leverage adjustment consideration is of first order importance to firms. We find that when firms are near the target debt ratios, external cash flow consideration seems to be more important, and when firms are far away from the target, leverage adjustment consideration seems to be more relevant. The result is consistent with Leary and Roberts’ notion of soft target. We also find evidence consistent with the extant literature that firms adjust their capital structures mainly through repurchase activities, and equity market timing plays a more important role in issuance activities.

JEL Classification: G32

Keywords: Capital Structure, Tradeoff Theory, Nested Logit