Macroeconomic Conditions and Capital Structure Adjustment Speed

Douglas O. Cook and Tian Tang*

Abstract Studies show that capital structure choice varies over time and across firms and that macroeconomic conditions are important factors in analyzing firms financing choices. However, studies have largely ignored the impact of macroeconomic conditions on the adjustment speed of capital structure toward targets. Hackbarth et al. (2006) develop a contingent model for analyzing the impact of macroeconomic conditions on dynamic capital structure choice. Allowing for dynamic capital structure adjustments, their model predicts that firms should adjust their capital structure faster in booms than in recessions. We employ U.S. data over a 30 year sample period to test the relationship between macroeconomic conditions and capital structure adjustment speed using both two-stage and integrated partial adjustment dynamic capital structure models. We find evidence supporting the prediction from Hackbarth et als theoretical framework that firms adjust to target leverage faster in good states than in bad states, where states are defined by term spread, default spread, GDP growth rate, and market dividend yield. Our results also support the pecking order theory in that under-levered firms adjust faster than firms that are over-levered. We find evidence favoring the market timing theory implication that under-levered firms have less incentive to adjust toward target leverage when stock market performance is good, as measured by dividend yield on the market and priceoutput ratio. Robustness tests demonstrate that our speed of capital structure adjustment cannot be simply explained by firm size, the degree of deviation from target, or by the definition of debt ratio. Our results are also robust to potential boundary issues. JEL classifications: G11; G18; G23 Keywords: Dynamic capital structure, speed of adjustment, macroeconomic conditions

Both authors are from the Culverhouse College of Business, University of Alabama, Tuscaloosa, AL 35487-0224. Cook: dcook@cba.ua.edu, (205) 348-8971. Tang: ttang@cba.ua.edu, (205) 239-5671. We thank Xudong Fu for helpful suggestions. Cook gratefully acknowledges financial support from the Ehney A. Camp, Jr. Chair of Finance and Investments.

Electronic copy available at: http://ssrn.com/abstract=1101664

2
Electronic copy available at: http://ssrn.com/abstract=1101664

1. Introduction Although there are corporate capital structure theories explaining firms financing decisions, little is known about how macroeconomic conditions affect the adjustment speed of capital structure towards target leverage. In this paper, we use two dynamic partial adjustment capital structure models to test the relationship between macroeconomic conditions and the adjustment speed of capital structure. The primary existing theories of corporate capital structure explaining firms financing decisions can be categorized as the tradeoff, pecking order, and market timing theories. In the tradeoff theory, firms select target leverage ratios based on an exchange between the benefits and costs of increased leverage (Modigliani and Miller, 1963, Jensen and Meckling, 1976, Myers, 1977, Stulz, 1990, Hart and Moore, 1995, and Ross, 1977). In the absence of any adjustment cost, firms would continuously offset deviations from target. The presence of large adjustment costs would likely slow down the

adjustment time.1 The pecking order theory suggests that investments are first financed by internal funds, then external debt, and, as a last resort, external equity (Myers and Majluf, 1984). According to this theory, firms do not have a strong incentive to rebalance their capital structures. It suggests a very slow adjustment speed towards a target debt ratio. Baker and Wurgler (2002) propose the market timing theory of capital structure, arguing that current capital structure is the cumulative outcome of past attempts to time the market. In this theory, there is no optimal capital structure and market valuation has a

Myers (1984) points out that large adjustment costs could force firms into long excursions away from their initial debt ratios. Fisher, Heinkel and Zechners (1989) dynamic tradeoff model in the presence of recapitalization costs indicates that firms actual leverage ratios deviate away from target ratios but firm characteristics explain some of the cross-sectional deviations.

persistent impact on capital structure.

However, Leary and Roberts (2005) provide

evidence contradicting the implications of market timing theory. They show that the persistent effect of shocks on leverage is more likely due to the presence of adjustment costs than to an indifference towards capital structure. Numerous papers suggest that firms financing decisions nudge them towards target leverage ratios, consistent with the tradeoff theory, but the evidence regarding adjustment speed is mixed. Survey results presented by Graham and Harvey (2001) indicate that about 80 percent of the CFOs in their sample affirm having a target range or strict debt-equity ratio target. In addition, managers express concern about the costs and advantages associated with debt financing. Shyam-Sunder and Myers (1999) test the static tradeoff theory against the pecking order theory and show that the latter has greater time series explanatory power. Their result suggests a slow adjustment speed toward target leverage. Other articles, such as Fama and French (2002), Baker and Wurgler (2002), Welch (2004), and Hovakimian (2006), also provide evidence of slow adjustment in capital structure. Several recent papers provide evidence of faster adjustment speed than in previous studies. Flannery and Rangan (2006) find a much faster adjustment speed after controlling for firm fixed effects. Leary and Roberts (2005) show that the impact of shocks on leverage is appropriately rebalanced away over the subsequent two to four years. Alti (2006) suggests that the impact of market timing activities in IPOs on leverage vanishes completely in two years. He concludes that the long-run market timing effect on leverage is limited and firms financing decisions in the long-run are largely consistent with leverage targets.

Lemmon et al. (2008) find that although there is some convergence toward the mean over time, cross-sectional variation in firms leverage ratios are closely related to initial leverage ratios even prior to firm IPOs. They also find that a significant portion of a firms capital structure is explained by firm fixed effects. Cook and Kieshnick (2008) relax the assumptions in Lemmon et al. that the conditional expectation functions of their proportional leverage measures should be linear functions of the explanatory variables. They show that the conditional expectation function is consistent with a sigmoidal function and that the convergence and persistence patterns observed by Lemmon, Roberts, and Zender can be explained by the two inflection points and characteristics of this sigmoidal function. They also show that the importance of firm fixed effects is reduced after controlling for the non-linear nature of the conditional expectation function, Studies show that capital structure choice varies over time and across firms and that macroeconomic conditions are important factors in analyzing firms financing choices (e.g. Choe, Musulis, and Nanda, 1993; Gertler and Gilchrist, 1994; Korajczyk and Levy, 2003).2 However, studies on the adjustment speed of capital structure derived from analyzing traditional capital structure theories as well as studies on the role of macroeconomic factors in capital structure choice have largely ignored the impact of macroeconomic conditions on the adjustment speed of capital structure toward targets. Hackbarth et al. (2006) develop a contingent model for analyzing the impact of macroeconomic conditions on dynamic capital structure choice. Allowing for dynamic

Choe, Musulis, and Nanda (1993) find equity issuance relative to the market value of bonds to be positively correlated with previous stock returns and various business cycle variables. Gertler and Cilchrist (1994) show that small firms have relatively more stable short-term debt over the business cycle than large firms. Korajczyk and Levy (2003) examine the impact of macroeconomic conditions on capital structure choice for financially constrained and unconstrained firms and find evidence that target leverage is countercyclical for financially constrained firms, while pro-cyclical for financially unconstrained firms.

capital structure adjustments, their model predicts that firms should adjust their capital structure faster in booms than in recessions. The only related empirical study is by Drobetz et al. (2006), who document a positive correlation between the business cycle and speed of capital structure adjustment for a sample of 91 Swiss firms. We employ U.S. data over a 30 year sample period to test the relationship between macroeconomic conditions and capital structure adjustment speed using both two-stage and integrated partial adjustment dynamic capital structure models. We find evidence supporting the prediction from Hackbarth et als (2006) theoretical framework that firms adjust to target leverage faster in good states than in bad states, where states are defined by term spread, default spread, GDP growth rate, and market dividend yield. Our results also support the pecking order theory in that under-levered firms adjust faster than firms that are over-levered. We find evidence favoring the market timing theory

implication that under-levered firms have less incentive to adjust toward target leverage when stock market performance is good, as measured by dividend yield on the market and price-output ratio. Robustness tests demonstrate that our speed of capital structure adjustment cannot be simply explained by firm size, the degree of deviation from target, or by the definition of debt ratio. Our results are also robust to potential boundary issues. The rest of the paper is as follows. Section 2 discusses the dynamic partialadjustment capital structure model used in this study and the specifications of variables. Section 3 describes the data and sample for the empirical analysis. Section 4 provides the empirical analysis results. Section 5 presents a series of robustness tests. Conclusions are in Section 6.

2. The model and specifications 2.1. Two models Since recent literature contains two distinct partial adjustment models, we employ both a two-stage and an integrated dynamic partial-adjustment capital structure model.

2.1.1. Two-stage dynamic partial-adjustment capital structure model We utilize a dynamic partial-adjustment capital structure model (Hovakimian et al., 2001; Drobetz and Wanzenried, 2006), which allows target debt ratios to vary both across firms and over time, and implies that deviations from targets are not necessarily quickly offset. Following previous studies on capital structure (e.g. Fama and French, 2002; Kayhan and Titman, 2007), we estimate the adjustment speed of capital structure towards target using two-stage estimations based on target leverage proxy from the firststage regression. The model is as follows:

Stage 1: Di,t*= Macrot-1 + Xi,t-1 (1)

Although previous studies obtain the fitted value of Equation (1) as the proxy for target leverage using linear regression models, Papke and Wooldridge (1996) point out that there are methodological problems using linear models for fractional data. To manage such problems, they develop a quasi-likelihood method with a fractional dependent variable. Thus, we follow Papke and Wooldridge (1996) and use the quasimaximum likelihood estimation method (QMLE) to estimate the fitted value of Equation (1) as the proxy for target leverage.

In a frictionless world, firms would move quickly back to their target level, which is the level chosen by firms in the absence of any adjustment costs (Hovakimian, Opler and Titaman, 2001; De Miguel and Pindado, 2001). However, in the presence of

adjustment costs, firms may adjust partially back to their desired leverage ratio over multiple periods. In the second stage, we use the standard partial adjustment model in the literature (Hovakimian, Opler and Titaman, 2001; De Miguel and Pindado, 2001) as follows:

Stage 2: Di,t - Di,t-1 = (Di,t* - Di,t-1) + i,t (2)

where represents the proportion of deviation away from the firms target leverage, closed by the firm from period t-1 to period t. In other words, the negative coefficient estimate before the lagged debt ratio captures the adjustment speed back toward target leverage, which is the main focus of this study. =1 indicates that firms fully adjust for any deviation away from their targets. In the presence of adjustment costs, as in this study, is expected to be less than 1. We estimate Equation (2) using standard OLS with robust t-statistics from standard errors corrected for heteroskedasticity.

2.1.2 Integrated dynamic partial-adjustment capital structure model Evaluating the two-stage estimation procedure that is commonly used in the literature, Flannery and Rangan (2006) show that the partial adjustment speed reflected by the coefficient on target leverage from first-stage regressions is abnormally smaller than theory would predict and that the long-term elasticity of the observed debt ratio

relative to its target is significantly different from unity. Thus, following Flannery and Rangan (2006), we estimate the impact of macroeconomic conditions on the capital structure adjustment speed by including the partial adjustment and firm fixed effects in one integrated capital structure model. Specifically, we model the target debt level of firm i in period t (Di,t) as a linear function of a set of lagged macroeconomic variables (Macrot-1) and firm characteristic variables (Xi,t-1), which are the same as in Equation (1). The standard partial adjustment model is equivalent to Equation (2). Then, substituting (1) into (2) and rearranging yields the following: Di,t = (1- ) Di,t-1 + Xi,t-1 + Macrot-1 + i,t (3)

We estimate the speed of capital structure adjustment from Equation (3) across good and bad macroeconomic states, respectively. During model estimation, we control for firm fixed effects since Flannery and Rangan (2006) find that this increases adjustment speed. We do not include year dummy variables in the subsequent panel regression since these may absorb the time-varying influence of macroeconomic conditions on capital structure.

2.2. Definitions of Leverage There is no consensus on whether book- or market-valued debt ratios should be used in capital structure studies. Some argue that leverage should be computed using the book value of capital because book ratios are independent of factors that are not under the direct control of firms (Fama and French, 2002; Thies and Klock, 1992). Others prefer market debt ratios. For example, Welch (2004) provides evidence that market leverage better reflects the agency problems between creditors and equity holders and can serve as

an indispensable input into WACC computations. Since it is highly possible that some firms have book value rather than market value targets and vice versa, we use both book and market leverage measures. Specifically, our book debt ratio is: BDi,t =

SDi ,t + LDi ,t TAi ,t

(4)

where SDi,t + LDi,t is the sum of firm is short-term and long-term book value of interestbearing debt at time t, and TAi,t denotes the book value of total assets. We use the following market debt ratio:

MDi,t=

SDi ,t + LDi ,t SDi ,t + LDi ,t + S i ,t Pi ,t

(5)

where SDi,t + LDi,t is the sum of firm is short-term and long-term book value of interestbearing debt at time t, and Si,tPi,t denotes the product of the number of common shares outstanding and the stock price per share at time t, which denotes the market value of firm is equity. We estimate our two models using both BDi,t and MDi,.

2.3. Determinants of leverage 2.3.1. Macroeconomic target determinants

There is evidence that macroeconomic variables can affect target leverage through the aggregated distribution of wealth between managers and outside shareholders (Kiyotaki and Moore, 1997; Levy, 2001). Korajczyk and Levy (2003) argue that

corporate profits and equity performance influences managers compensation. Therefore, following Korajczyk and Levy, we use three proxies for the aggregate distribution effect:

CPG, VRMR, and CPSPREAD where CPG represents the two-year aggregate domestic
non-financial corporate profit growth, obtained from the annual Flow of Funds database

10

on the Federal Reserve website; VRMR equals the two-year value-weighted market return of stocks traded on the NYSE/AMEX/NASDAQ, extracted from CRSP; and

CPSPREAD is the commercial paper spread, computed from the spread between the
annualized rate of three-month commercial paper and the three-month Treasury bill.3

2.3.2. Firm characteristics determinants

We follow the literature and use a standard set of firm determinants of leverage (Ranjan and Zingales, 1995; Hovakimian, 2003; Hovakimian et al., 2001; Fama and French, 2002; Flannery and Rangan, 2006).

MB is the ratio of market value to book value of total assets. There is mixed
evidence on the relationship between MB and leverage ratio. For example, higher MB could be viewed as a sign of greater future investment opportunities which firms may try to protect by restraining their leverage (e.g. Hovakimian et al., 2004; Flannery and Rangan, 2006). On the other hand, a simple version of the pecking order theory implies that leverage increases when investment exceeds retained earnings (Drobetz et al., 2006).

TANG is the ratio of gross property, plant and equipment to total assets. Firms
with greater tangible assets, potentially collateralized, are likely to have relatively lower bankruptcy costs, and thus, higher debt capacity (Titman and Wessels, 1998; Hovakimian et al,. 2004).

We obtain the aggregate domestic non-financial corporate profit growth rate from the Annual Flow of Funds database on the Federal Reserve Boards web page at http://www.federalreserve.gov/releases. The commercial paper rate and the Treasury bill rate are from the Federal Reserve Boards web page at http://www.federalreserve.gov/releases.

11

EBIT is the ratio of earnings before interest and taxes to total assets. Firms with
higher earnings per asset dollar tend to operate with lower leverage ratios because high retained earnings reduce the need to issue debt.

DEP equals the ratio of depreciation to total assets.

Firms with higher

depreciation expenses are less likely to issue debt for tax shield purposes. LNTA is the natural logarithm of total assets, which we use as a proxy for firm size. Larger firms tend to have higher leverage ratios because they have lower cash flow volatility, better access to financial markets, and are less likely to become financially distressed (Rajan and Zingales, 1995; Hovakimian et al., 2004). We use the variables RD, RDD, and SE to proxy firm uniqueness. RD is the ratio of R&D expenses to firm book assets. RDD is a dummy variable that takes the value of 1 if firms report R&D expenses and 0, if otherwise. SE equals selling expenses scaled by total sales. Firms with higher R&D expenses and higher selling expenses tend to have unique assets and develop unique products, which may indicate higher bankruptcy costs (Titman, 1984; Hovakimian et al., 2004). Thus, firms with higher R&D and selling expenses are more likely to protect themselves with lower leverage ratios. In order to control for industry characteristics which may not be captured by other independent variables, we include the firms industry median debt ratio, where the industry is identified by using the Fama and French 49 industry definition. To test the effect of current leverage levels relative to target, we construct

LEVDUMMY, which takes the value of one if a firm-year observation is over-levered, i.e.
when (Di,t-1 Di,t-1*) is greater than zero, but otherwise takes the value of zero.4

Since Lemmon et al. (2008) argue that most of the variation in firms leverage ratios is closely related to their initial leverage ratios, we add initial leverage ratios to our models explanatory variables. We find

12

2.4. Macroeconomic factors

In order to test the impact of macroeconomic conditions on the speed of capital structure adjustment, it is important to analyze the macroeconomic factors that define macroeconomic conditions. We employ such a set of factors, commonly used in the

literature as indicators of macroeconomic conditions. These factors include term spread, default spread, GDP growth rate, market dividend yield, and the price-output ratio. We measure term spread as the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series. High term spread is viewed as a strong predictor for a good economy (Stock and Watson, 1989; Estrella and Mishkin, 1998). Thus, we expect faster adjustment speed in good macroeconomic

conditions as predicted by a high term spread.5 Following Korajczyk and Levy (2003) and Fama and French (1989), we define default spread as the difference between the average yield of bonds rated Baa and the average yield of bonds rated Aaa, each rated by Moodys and with a maturity between 20 and 25 years. Tracking long-term business cycle conditions, this indicator is higher during recessions and lower during expansions (Fama and French, 1989). Thus, we expect that firms will adjust capital structure faster when default spreads are lower.6

that although the adjustment speed estimates from our models are reduced by about 20 percent in magnitude in each scenario, the signs and significance of the key regressors are consistent with those obtained from estimating models without the initial leverage ratio. In other words, the impact of macroeconomic conditions on firm adjustment speed remains significant even after considering the initial leverage ratio. We do not report these results in the tables. 5 Drobetz (2006) uses the three month money market interest rate as a macroeconomic factor but Estrella and Hardouvelis (1991) argue that the slope of the yield curve has more predictive power than the shortterm interest rate. 6 Similar measures in the literature include the yield difference between AAA rated corporate bonds and government bonds (Drobetz, 2006), the yield difference between high yield corporate bonds and AAA

13

Since an economic recession is traditionally defined as a decline in real Gross Domestic Product (GDP) for two or more successive quarters of a year, we use the real GDP growth rate over quarters in a year as a direct indicator of macroeconomic conditions. We expect a faster adjustment speed in good macroeconomic conditions as indicated by a higher contemporaneous real GDP growth rate. Although these three macroeconomic factors are unambiguous predictors of adjustment speed, the pecking order theory suggests that under-levered firms should adjust faster than over-levered firms due to the preference of issuing new debt compared to issuing new equity. In order to test this effect, we measure the impact of leverage level relative to target on adjustment speed. We also employ two stock market performance-related macroeconomic factors: market dividend yield and price-output ratio. Market dividend yield equals total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. Since dividend levels tend to be sticky, a high dividend yield indicates low stock prices, which are more likely in economic contractions (Drobetz, 2006). Therefore, we anticipate that the adjustment speed of capital structure will be higher when the dividend yield is lower. As an indicator of future stock market performance, we use the price-output ratio, calculated as the S&P stock price index in January in a given year scaled by GDP from the previous year.7 This price-output ratio has been shown to track a substantial fraction of variation in both expected returns and excess returns on the aggregate stock market,
corporate bonds, and the difference between the high yield corporate bond rate and the rate of 10-year Treasury bonds (Gertler and Lown, 1999). 7 The S&P stock price index is available from Robert Shillers hompage at http://www.econ.yale.edu/~shiller/data.htm while GDP data is available from the website of the U.S. Department of Commerce at http://www.bea.gov/bea.

14

capturing a larger fraction of this variation than price-earnings and price-dividend ratios (Rangvid, 2006).8 The mean reversion in the price-output ratio implies that expected returns are high if current stock prices are low relative to current GDP. Thus, ceteris paribus, we expect the adjustment speed of capital structure to be higher when the priceoutput ratio is lower.9 However, if firms time equity issuance (Baker and Wurgler, 2002), they would be reluctant to issue equity when stock prices are low. The confluence of these two effects makes prediction difficult. For example, suppose the firm is over-levered and the priceoutput ratio is low. The firm wishes to issue equity to move toward the leverage target but is reluctant to do so because stock prices are low. However, if the firm is underlevered, then it could issue debt and move towards its target ratio. Due to these

conflicting influences, we analyze the effect of being over-levered and under-levered on adjustment reactions.

2.5. Defining good and bad states of macroeconomic conditions

Since we intend to examine the impact of macroeconomic conditions on capital structure adjustment speed by estimating and comparing the adjustment speed across good and bad macroeconomic states, it is necessary to identify the good and bad macroeconomic states based on the macroeconomic factors discussed in the previous section. We proceed by dividing the 30 year sample period from 1976 to 2005 into quintiles based on the order of each macroeconomic factor. For divisions based on the
Korajczyk and levy (2003) use the three-month CRSP value-weighted equity market returns as a proxy of stock market performance. 9 In consideration of the fact that the price-output ratio may predict stock returns farther into the future, we also re-estimate the price-output ratio lagged an additional year. These results, not reported, are consistent with the results obtained using the price-output ratio.
8

15

term spread and GDP growth rate factor, we equate good macroeconomic states with the highest quintile factor years, moderate macroeconomic states with the mid-three quintile factor years, and bad macroeconomic states with the lowest quintile factor years since, as discussed in Section 2.4, good states are defined as higher past term spreads and higher current GDP growth rate. For divisions based on default spread, dividend yield, and price-output ratio, we equate good macroeconomic states with the lowest quintile factor years, moderate macroeconomic states with the mid-three quintile factor years, and bad macroeconomic states with the highest quintile factor years because good macroeconomic conditions are defined in terms of lower past default spread, lower dividend yield, and lower past price-output ratio.

3. Data and sample We obtain the primary sample of firm-year observations used in this study from Compustats Industrial Annual Database over the sample period 1976 to 2005. Consistent with earlier studies, we exclude financial firms (6000-6999) and utilities (4900-4999) from the sample because they are usually regulated and special factors might be incorporated into their capital structure decisions (Fama and French, 2002; Frank and Goyal, 2003; and Korajczyk and Levy, 2003). In order to be included in the sample, the firm must have complete data available in two adjacent years. We exclude observations with leverage levels that fall outside the outlier leverage levels of [0,1]. Our final sample consists of 127,665 firm-year observations for analysis based on the book-valued debt ratio and 129,936 firm-year observations for analysis based on the market-valued debt ratio.

16

We extract the cash dividend amount and market capitalization from CRSP to compute the dividend yield on the market. We obtain other relevant macroeconomic variable information from the website of the Federal Reserve Board, U.S Department of Commerce and Robert Shillers homepage.10

4. Empirical Analysis

4.1. Summary Statistics

Table 1 Panel A reports the mean, median and standard deviation of the debt ratios over the sample period, 1976 to 2005. Consistent with the argument in the

literature that book-valued debt ratios are less subject to non-controllable firm factors, we find that the book debt ratio fluctuates less over the sample period than the market debt ratio. Both the market-based and book value-based debt ratios, are relatively low in the stock market expansion periods of the 1990s, increase slightly during the internet crash at the millennium, and then decrease as the stock market begins its recovery. This is consistent with the view that firms time their equity issuance and have less incentive to issue debt when the stock market performs well. Table 1 Panel B demonstrates the substantial actual and absolute levels of deviation from target leverage. For example, the actual book (market) debt ratio deviation from target ranges from -.2259 (-.2710) to .3026 (.3598) across quintiles. Table 2 Panels A and B present the univariate tests of leverage variables across good and bad states of macroeconomic conditions defined by different macroeconomic factors. For each factor (i.e. the criteria dividing macroeconomic conditions into states
The Federal Reserve Boards website is at http://www.federalreserve.gov/releases, the U.S. Department of Commerces website is at http://www.bea.gov/bea, and Robert Shillers homepage is at httpe://www.econ.yale.edu/~shiller/data.htm.
10

17

including term spread, default spread, GDP growth rate, dividend yield, and price-output ratio), we report the means and medians in good and bad states, and the differences in means and medians between good and bad states. We also report P-values assuming unequal variances in variables between good and bad state sub-samples. The result shows that debt ratios are generally significantly higher in bad states than in good states, regardless of how the debt ratio is measured. This counter-cyclical feature for debt levels is consistent with theories developed and evidence provided in the literature.11 The median debt ratios across good and bad states exhibit the same pattern as the mean debt ratios. Table 2 Panel C shows that there is a smaller percentage of over-leveraged firms than under-leveraged firms in each state regardless of the division criterion. This is consistent with the modified pecking order story (Myers, 1984) that indicates firms are concerned less about excessively low leverage than they are about excessively high leverage.

4.2. Adjustment speed estimates

In this section, we estimate capital structure adjustment speed based on the integrated dynamic partial adjustment model and the two-stage dynamic partial adjustment model and illustrate results in Table 3 and Table 4, respectively. Macroeconomic factors are term spread, default spread, GDP growth rate, dividend yield
11

Theoretically, Levy (2001) develops an agency model in which the optimal amount of leverage is increased to realign managers incentives with those of shareholders in recessions. Hackbarth et als (2006) framework for analyzing the impact of macroeconomic conditions on dynamic capital structure choice predicts that leverage ratios should be countercyclical. Empirically, Choe et al. (1993) and Bayless and Chaplinsky (1996) present evidence that equity issuance increases during expansions due to the countercyclical variation in adverse selection costs. Korajczyk and Levy (2003) also provide evidence of the counter-cyclical feature of the debt level.

18

and price-output ratio.

To detect pecking order effects, we analyze the impact on

adjustment speed of a firm being over or under-levered relative to target on the first three factors. To detect timing effects, we observe the net effect on adjustment speed of macroeconomic factors and market timing as well as the interaction of over- or underleverage with the dividend yield and price-output ratio. We measure leverage using both book value and market value.

4.2.1. Integrated dynamic partial adjustment capital structure model

We control for firm fixed effects and report the results from estimating Equation 3 in Table 3, Panels A through E. For each panel, columns 2 through 4 present regression results for the good, bad and pooled sub-samples when debt ratio is computed on a book value basis. Columns 5 through 7 present these same results when debt ratio is computed on a market value basis. In order to compare the difference in the speed of capital structure adjustment towards target between good and bad states, we include an interaction term, computed by the product of the lagged debt ratio and the good state dummy variable, which takes the value of 1 if the firm-year observation belongs to a good state and takes the value of 0 if otherwise. Panel A presents estimation results for Equation (3), when the states of macroeconomic conditions are defined by term spread. The results show that, for both book- and market-valued debt ratios, firms adjust their capital structure back to target leverage faster in good states than in bad states. Specifically, for the book-value debt ratio, firms close in one year about 79.1% (since 1-=20.9%) of the gap between the actual and target debt ratio in good states, while they only correct about 65.2% of

19

deviation away from target in bad states. The negative coefficient estimate on the interaction term between the lagged debt ratio and the good state dummy in the pooled regression is further evidence that adjustment is faster in good states than in bad states.12 The positive coefficient on the interaction term between the lagged debt ratio and the leverage dummy variable provides supporting evidence for the pecking order theory as underleveraged firms with little reluctance to issue external debt adjust faster than over-levered firms. 13 The same patterns occur when debt ratios are measured on a market-value basis, in which case firms adjust in one year about 79.3% of the deviation from target leverage in good states, while they only adjust 68.5% back to target in bad states. Again, the difference in adjustment speed estimates across the two states is significant and the signs of the interaction terms are identical. Panels B and C report results when the determinants of states depend on default spread and GDP growth rate. All results show that the adjustment speed of capital structure is faster in good states than in bad states, from both a book and market debt ratio perspective. This is consistent with the prediction of Hackbarth et als (2006) model. As in Panel A, these results also contain support for the evidence of pecking order effects. Panels D and E illustrate the regression results from estimating Equation (3), when the states of macroeconomic conditions are defined by market dividend yield and price-output ratio. As discussed in Section 2.4, market timing can act as a confounding effect when macroeconomic conditions are defined by these two stock market performance related factors. Thus, the measure of a firms adjustment speeds toward

12

The negative interaction coefficient implies faster adjustment because the coefficient on the lagged debt ratio is 1-, where is the proportion of deviation from target leverage closed from period t-1 to period t. 13 The positive coefficient on the leverage dummy enhances the ratio 1-, resulting in a slower adjustment, , for over-levered firms and a faster adjustment for under-levered firms.

20

target observed from the estimations on separate good and bad state sub-samples is not sufficiently informative. Therefore, we include the interaction term GOODDUMMY * LEVDUMMY * BDt-1/MDt-1 in the pooled sample to capture additional evidence regarding the timing effect on adjustment speed. The resulting mostly significantly negative signs for this new interaction term suggests that in good states, defined as good stock market performance, over-levered firms tend to adjust faster than under-levered firms. This is consistent with predictions from the market timing theory since firms

that are timing the market are inclined (reluctant) to issue equity (debt) in periods with good stock market performance.

4.2.2. Two-stage dynamic partial adjustment capital structure model

Table 4, Panels A through E, report the results from estimating the capital structure adjustment speed using the two-stage model when good and bad states are defined by term spread, default spread, GDP growth rate, dividend yield and price-output ratio, respectively. We do not report the results from the first-stage regressions since the coefficient estimates of firm characteristics and macroeconomic target determinants are generally consistent with previous studies. We find that firms tend to adjust faster towards target leverage in good states than in bad states when states are determined by term spread, default spread, and GDP growth rate. These results are consistent with the adjustment pattern under the integrated The negative coefficient estimates on the

regression method is used in Table 3.

interaction terms between the lagged debt ratios and the good state dummies in the

21

pooled regressions are further evidence that adjustment is faster in good states than in bad states.14 Similar to Roberts (2002) and Flannery and Rangan (2006), we find that the magnitude of adjustment speed is relatively smaller in the two-stage model. For example, in Table 4 Panel A where states are determined by term spread, the coefficient on the lagged debt variable indicates that firms close about 62.7% of the deviation from target leverage in good states and close about 53.7% in bad states when book-value based debt is used, while the counterpart results from integrated regression suggest 79.1% in good states and 65.2% in bad states.15 The positive coefficient on the interaction term between the lagged debt ratio and the leverage dummy variable provides supporting evidence for the pecking order theory since over-levered firms adjusting slower is consistent with the pecking order reluctance to issue equity versus external debt.16 Results for states determined by the market dividend yield and price-output ratio are consistent with those obtained from the integrated dynamic partial adjustment model estimation. The negative coefficients from mixing the leverage dummy variables with the interactions between the lagged debt ratios and the good state dummy variables suggests that over-levered firms adjust faster than under-levered firms in good states, for both book-valued and market-valued debt ratios. This provides evidence supporting the

14

The negative coefficient enhances the magnitude of the negative coefficient on the lagged debt ratio, which equals . 15 From equation 2 in the two-stage model, the coefficient on the lagged debt ratio represents the negative of the proportion of deviation from target leverage closed from period t-1 to period t not 1 minus this proportion as in equation 3 from the integrated model. 16 Being over-levered reduces the adjustment speed because the magnitude of the negative coefficient on the lagged debt ratio () is reduced by the positive interaction coefficient.

22

market timing hypothesis since over-levered firms have more incentive than underlevered firms to adjust toward target when stock prices are high.

5. Robustness

5.1. Boundary issues

Cook, Kieschnick, and McCullough (2008) address the specification error that arises when the decision of whether to issue a type of financing is assumed to be equivalent to the decision on how much of that financing to use. The application for this paper is that including zero-debt issuance firms may cause a bias in our adjustment speed estimate. Thus, we re-estimate the adjustment speed using the integrated and two-stage dynamic partial adjustment models on sub-samples but leaving out the zero-debt issuance firm-year observations. We report only the coefficient estimates before the key

regressors from the integrated (two-stage) model in Table 5 (6). We find that the adjustment speed estimates from both models on the new sub-samples are consistent with those in the original sub-samples with firms adjusting faster toward targets in good states compared to bad states when states are determined by term spread, default spread, and GDP growth rate. Consistent with the pecking order theory, the positive coefficients on the interaction term between the lagged debt ratios and the leverage dummy variables indicate that under-levered firms with little reluctance to issue external debt adjust faster than over-levered firms. Consistent with market timing, we find that over-levered firms tend to adjust faster than under-levered firm when states are defined by the market

23

dividend yield and price-output ratio. Thus, our results on adjustment speed are not affected significantly by including zero-debt issuance firm-year observations.

5.2. Firm size impact

Drobetz (2006) argues that large firms should be able to more easily correct deviations from debt targets because they have better assess to public debt markets and have relatively lower adjustment costs. This suggests that there may be a positive relationship between firm size and the speed of capital structure adjustment. Therefore, our realized state-dependent faster adjustment speed may be attributable to the larger size of firms in those states rather than to macroeconomic factors. Therefore, we examine the differences in the mean logarithm of total assets, a proxy for firm size, across good and bad states as defined by our five macroeconomic factors. The results, shown in Table 7, indicate that, although the differences in mean firm size between good and bad states are generally significant, regardless of the definition used to define states, the signs of the differences are mixed. In other words, there is no strong pattern showing firm size to be larger in the states where faster adjustment speed is observed. Thus, since there is no significant distinction in firm size across good and bad states, the faster adjustment speed found in good states is not attributable to the larger size of firms in those states.

5.3. Distance away from target

Since it is documented that firms farther away from target leverage adjust faster (Drobetz, 2006), another possible explanation for our results is that firms tend to deviate more from their target debt level in good states when states are defined by term spread,

24

default spread, GDP growth rate, and market dividend yield, and tend to deviate less in good states when states are defined by the price-output ratio.17 Therefore, this relative deviation rather than the impact of macroeconomic conditions may lead to a faster adjustment of capital structure. We examine the difference in mean absolute value of deviation from the target level between good and bad states to test whether firms tend to deviate further in good states than in bad ones. We measure this deviation from the target debt ratio as the distance between the actual and target debt ratio as follows,

DISi,t = D i, t * - D i, t

(6)

where Di,t*= Macrot-1 + Xi,t-1, Macro is a set of macroeconomic target variables and X is the vector of firm characteristics determining the target debt level, and D could be either the book-value debt ratio or the market-value debt ratio. We follow Papke and Wooldrige (1996) and use the quasi-maximum likelihood estimation method (QMLE) to estimate the fitted value of Equation (1) as the proxy for target leverage and report the results in Table 8. The mean difference in distance between actual and target debt ratios relative to good and bad states, where states are based on term spread, default spread, GDP growth rate, dividend yield and price-output ratio are reported, respectively. The results do not support firms being consistently farther away from their target in good states compared to bad states. Therefore, the faster adjustment speed of capital structure in good states cannot be attributed to the fact that the distance between actual and target debt ratios tends to be greater in those states.

5.4. Alternative measurements of debt ratio

17

In states defined by the price-output ratio, the market timing effect on adjustment speed dominates the macroeconomic conditions effect.

25

Since the definition of leverage varies across capital structure studies, we analyze whether our results are robust to different definitions of debt ratio. We employ three alternative forms of market-valued debt ratios commonly used in the literature and re-estimate the two-stage and integrated partial adjustment models. The alternative market-valued debt ratios are defined as follows:
MD1i,t= SDi ,t + LDi ,t TAi ,t BEi ,t + S i ,t Pi ,t TLi ,t TLi ,t + S i ,t Pi ,t

(7)

MD2i,t=

(8)

MD3i,t=

LDi ,t TAi ,t CLi ,t BEi ,t + S i ,t Pi ,t

(9)

where SDi,t + LDi,t is the sum of the book value of firm is short-term and long-term interest-bearing debt at time t; Si,tPi,t represents the product of the number of common shares outstanding and stock price per share at time t, which is the market value of firm is equity; TAi,t denotes the book value of firm is total assets at time t; BEi,t is the book value of firm is equity; TLi,t represents the book value of firm is total liabilities at time t;

CLi,t denotes current liabilities of firm i at time t, and BEi,t is the book value of equity of
firm i at time t. For brevity, we do not report the results in tables. However, consistent with our previous results we find that, regardless of the debt ratio definition, firms tend to adjust faster towards target leverage in good states than in bad states when states are defined by term spread, default spread, and GDP growth rate, and dividend yield. When market dividend yield and price-output ratio are used as the criterion to distinguish between good and bad states, the results provide strong evidence of the market timing theory.

26

Altogether, the results from the estimations when alternative market-valued debt ratios are used are consistent with the previous results when primary book and market debt ratios are analyzed.

6. Conclusion

We study the impact of macroeconomic conditions on the speed of capital structure adjustment by analyzing U.S data over the sample period from 1976 to 2005. We find that firms adjust faster toward target leverage in good states than in bad ones, when states are defined by term spread, default spread, GDP growth rate, and market dividend yield, a finding that is consistent with the prediction from Hackbarth et al. (2006)s theoretical model. Our results also support the pecking order theory in that firms that are under-levered adjust faster than firms that are over-levered. We find evidence favoring the market timing theory implication that underlevered firms have less incentive to adjust toward target leverage when stock market performance is good,. We also find evidence consistent with predictions from the market timing theory. When good states are defined as the dividend yield on the market and price-output ratio, which captures the variation of expected aggregate stock market returns, under-levered firms are less likely to adjust their leverage ratio towards target than over-leveraged firms. In other words, we find slower adjustment speed for under-leveraged firms in good macroeconomic conditions, indicated by lower dividend yield and lower past price-output measured by lower dividend yield and lower past price-output ratio.

27

Since it is possible that the faster speed of capital structure adjustment found is due to firms being larger, or to firms deviating farther from target leverage in those states, or to the definition of leverage, we show that our results are robust across these characteristics. Our results are also robust to possible boundary issues.

28

References

Alti, A., 2006. How persistent is the impact of market timing on capital structure? Journal of Finance, forthcoming. Baker, M., Wurgler, J., 2002. Market timing and capital structure. The Journal of Finance 57, 132. Bayless M., Chaplinsky, S., 1990. Expectations of security type and the information content of debt and equity offers. Journal of Financial Intermediation 1, 195-214. Chen, N., 1991. Financial investment opportunities and the macroeconomy. Journal of Finance 46, 529-554. Choe, H., Masulis, R., Nanda, V., 1993. Common stock offerings across the business cycle: theory and evidence. Journal of Empirical Finance 1, 3-31. Cook, D., Kieschnick, R., McCullough, B., 2008. Regression Analysis of Proportions in
Finance with Self Selection, forthcoming, Journal of Empirical Finance.

Cook, D., Kieshnick, R., 2008. On the nature of corporate capital structure persistence. Working paper. De Miguel, A., Pindado, J., 2001. Determinants of the capital structure: New evidence from Spanish data, Journal of Corporate Finance 7, 77-99. Drobetz, W., Wanzenried, G., 2006. What determines the speed of adjustment to the target capital structure? Applied Financial Economics 16, 941-961. Estrella A., Hardouvelis, G., 1991. The term structure as a predictor for real economic activity. Journal of Finance 46, 555-576. Estrella, A., Mishkin, F., 1998, The predictive content of the interest rate term spread for future economic growth. Federal Reserve Bank of Richmond Economic Quarterly. Fama, E., French, K., 1989. Business conditions and expected returns on stocks and bonds. Journal of Financial Economics 25, 23-49. Fama, E., French, K., 2002. Testing tradeoff and pecking order predictions about dividends and debt. The Review of Financial Studies 15, 1-33 Fischer, E., Heinkel, R., Zechner, J., 1989. Dynamic capital structure choice: Theory and tests. Journal of Finance 44, 19-40. Flannery, M., Rangan, K., 2006. Partial adjustment toward target capital structures. Journal of Financial Economics 79, 469-506. 29

Frank, M., Goyal, V., 2003. Testing the pecking order theory of capital structure. Journal of Financial Economics 67,217-248. Gertler, M., Gilchrist, S., 1993. The role of credit market imperfections in the monetary transmission mechanism: arguments and evidence. Scandinavian Journal of Economics 95, 43-63. Gertler, M., Lown, C., 1999. The information in the high-yield bond spread for the business cycle: Evidence and some implications. Oxford Review of Economic Policy 15, 132-150. Graham, J., Harvey, C., 2001. The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics 60, 186-243. Hart, O., Moore, J., 1995. Debt and seniority: an analysis of the role of hard claims in constraining management. American Economic Review 85, 567-585. Hackbarth, D., Miao, J., Morellec, E., 2006. Capital structure, credit risk, and macroeconomic conditions. Journal of Financial Economics 82, 519-550. Hovakimian, A., Opler, T., Titman, S., 2001. The debt-equity choice: an analysis of issuing firms. Journal of Financial and Quantitative Analysis 36, 124. Hovakimian, A., 2003. Are observed capital structures determined by equity market timing?. Working paper. Baruch College. Hovakimian, A., Hovakimian, G., Tehranian, H., 2004. Determinants of target capital structure: the case of dual debt and equity issues. Journal of Financial Economics 71, 517540. Hovakimian, A., 2006. Are observed capital structures determined by equity market timing? Journal of Financial and Quantitative Analysis 41, 221-243. Jensen, M., Meckling, W., 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305-360. Kayhan, A., Titman, S., 2007. Firms histories and their capital structure. Journal of Financial Economics 83, 1-32. Kiyotaki, N., Moore, J., 1997. Credit cycles. The Journal of Political Economy 105, 211248. Korajczyk, R., Levy, A., 2003. Capital structure choice: macroeconomic conditions and financial constraints. Journal of Financial Economics 68, 75109.

30

Leary, M., Roberts, M., 2005. Do firms rebalance their capital structure? Journal of Finance 60, 2575-2619 Lemmon, M., Roberts, M., Zender, J., 2008. Back to the beginning: persistence and the cross-section of corporate capital structure. Journal of Finance, forthcoming. Levy, A., 2001. Why does capital structure vary with macroeconomic conditions? Working Paper, Haas School of Business. Modigliani, F., Miller, M., 1963. Corporate income taxes and the cost of capital: a correction. American Economic Review 53, 433-443 Myers, S., 1977. Determinants of corporate borrowing. Journal of Financial Economics 5, 147-175. Myers, S., Majluf, N., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics 13, 187-221. Papke, L., Wooldridge, J., 1996. Econometric methods for fractional response variables with an application to 401(k) plan participation rates. Journal of Applied Econometrics 11, 619-632. Rajan, R., Zingales, L., 1995. What do we know about capital structure: some evidence from international data. Journal of Finance 50, 14211460. Rangvid, J., 2006. Output and expected returns. Journal of Financial Economics 81, 595624. Roberts, M., 2002. The dynamics of capital structure: an empirical analysis of a partially observable system. Duke Working paper. Ross, S., 1977. The determination of financial structure: the incentive-signaling approach. Bell Journal of Economics 8, 23-40 Shyam-Sunder, L., Myers, S., 1999. Testing static tradeoff against pecking order models of capital structure. Journal of Financial Economics 51, 219-244. Stock, J. H., Waterson, M.W. 1989. New Indexes of Coincident andLeading Economic Indicators, NBER Macroeconomics Annual, Cambridge, Mass.:MIT Press, 35294. Stulz, R., 1990. Managerial discretion and optimal financing policies. Financial Economics 26, 3-28. Journal of

Thies, C., Klock, M., 1992. Determinants of capital structure. Review of Financial Economics 1, 40-52.

31

Titman, S., 1984. The effect of capital structure on a firm's liquidation decision. Journal of Financial Economics 13, pp. 137151. Titman, S., Wessels, R., 1988. The determinants of capital structure choice. Journal of Finance 43, pp. 118. Welch, I., 2004. Capital structure and stock returns. Journal of Political Economy 112, 106131.

32

Table 1 Summary statistics of leverage Panel A presents the annual mean, median and standard deviation of leverage variables from 1976 to 2005. Panel B reports the actual and absolute deviation values from target leverage by quintiles over the sample period. We calculate target leverage according to equation (1) and employ the quasi-maximum likelihood estimation method to fit values. The sample includes all Industrial Compustat firms with complete data for two adjacent years. The debt ratios are defined as follows: BD is the book-valued debt ratio computed by (long-term book debt + short-term book debt)/total book assets. MD is the marketvalued debt ratio computed by (long-term book debt + short-term book debt)/(long-term book debt + short-term book debt + stock price* number of shares outstanding), Longand short-term debt and total assets numbers are in book values. We report overall numbers of observations.

Panel A. Actual leverage statistics

BD 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Mean 0.2545 0.2578 0.2638 0.2736 0.2737 0.2681 0.2691 0.2544 0.2557 0.2653 0.2724 0.2753 0.2775 0.2853 0.2832 0.2663 0.2456 0.2290 0.2267 0.2343 0.2324 0.2411 0.2577 0.2596 0.2518 0.2463 0.2385 0.2239 0.2090 Median 0.2379 0.2401 0.2502 0.2600 0.2567 0.2451 0.2442 0.2204 0.2271 0.2353 0.2449 0.2514 0.2511 0.2571 0.2574 0.2399 0.2173 0.1978 0.1987 0.2098 0.2032 0.2086 0.2275 0.2361 0.2219 0.2124 0.2002 0.1908 0.1703 Std 0.1745 0.1713 0.1705 0.1720 0.1813 0.1840 0.1959 0.1984 0.1973 0.2037 0.2093 0.2087 0.2126 0.2213 0.2214 0.2166 0.2081 0.1981 0.1960 0.1974 0.2024 0.2138 0.2227 0.2190 0.2218 0.2240 0.2216 0.2114 0.2045 obs 3140 3080 2994 3048 3334 3397 3861 3902 3986 4094 4026 4168 4274 4123 4063 4037 4100 4327 4593 4774 5201 5669 5591 5399 5292 5157 4853 4589 4454 Mean 0.3680 0.3722 0.3666 0.3709 0.3472 0.3397 0.3448 0.2735 0.2932 0.2892 0.2852 0.2934 0.3031 0.2990 0.3371 0.3043 0.2650 0.2282 0.2258 0.2336 0.2297 0.2292 0.2683 0.2771 0.2958 0.2903 0.2954 0.2371 0.1960 MD Median 0.3451 0.3592 0.3511 0.3517 0.3103 0.3043 0.3076 0.2164 0.2431 0.2404 0.2315 0.2390 0.2508 0.2370 0.2841 0.2353 0.1932 0.1597 0.1669 0.1705 0.1579 0.1535 0.1950 0.2007 0.2072 0.1934 0.2064 0.1514 0.1206 Std 0.2543 0.2483 0.2395 0.2434 0.2529 0.2543 0.2654 0.2407 0.2453 0.2442 0.2467 0.2480 0.2547 0.2590 0.2812 0.2748 0.2556 0.2300 0.2208 0.2304 0.2349 0.2391 0.2637 0.2727 0.2924 0.2936 0.2930 0.2583 0.2245 obs 3132 3078 2989 3048 3335 3405 3891 3942 4005 4099 4057 4142 4221 4104 4047 4044 4094 4286 4565 4829 5298 5808 5765 5619 5542 5460 5188 4894 4708

33

2005 Overall

0.2017 0.2517

0.1579 0.2257

0.2015 0.2065

4139 127665

0.1887 0.2819

0.1157 0.2176

0.2186 0.2592

4341 129936

Panel B. Actual and absolute deviations from target leverage BD Quintile1 Quintile2 Quintile3 Actual deviations from target leverage -.2259 -.1244 -.0324 Absolute deviations from target leverage .0262 .0804 .1334
Quintile1 Actual deviations from target leverage Absolute deviations from target leverage -.2710 .0305
MD Quintile2

Quintile4 .0801 .1926 Quintile4 .0820 .2288

Quintile5 .3026 .3361 Quintile5 .3598 .4020

Quintile3 -.0516 .1535

-.1429 .0924

34

Table 2 Summary statistics of leverage across states This table presents differences in means and medians of leverage variables across states over the sample period 1976 to 2005 in Panel A and Panel B. Panel C presents the percentage of over-leveraged firms across states over the same sample period. We determine states using five macroeconomic factor indicators. These five macroeconomic factor indicators are as follows: (1) Term spread: measured as the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series; (2) Default spread: defined as the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with Moodys rating of AAA; (3) GDP growth rate: defined as the average real GDP growth rate over quarters in a year; (4) Dividend yield on the market: defined as total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t; (5) Price-output ratio: computed as the S&P stock price index in January in a given year scaled by GDP from the previous year. We divide the 30 years in the sample periods into macroeconomic quintiles based on each macroeconomic factor. Sorting by term spread or GDP growth rate factor places years in the highest macroeconomic quintile -- good state (lowest macroeconomic quintile bad state) when term spread and GDP growth rate are in the highest (lowest) quintile. Sorting by default spread, dividend yield or price-output ratio places years in the highest macroeconomic quintile -- good state (lowest quintile bad state) when default spread, dividend yield or price-output ratio are in the lowest (highest) quintile. We report p-values.
Panel A. Summary statistics of book-valued debt ratio across states GDP Growth Term Spread Default Spread Rate Mean Median Mean Median Mean Median 0.233 0.200 0.243 0.215 0.258 0.233 Good 0.265 0.241 0.265 0.237 0.267 0.242 Bad G vs. B p-value -0.032 <.0001 -0.041 <.0001 -0.022 <.0001 -0.022 <.0001 -0.009 <.0001 -0.009 <.0001 Price-output Ratio Mean Median 0.266 0.244 0.245 0.212 0.021 <.0001 0.031 <.0001

Dividend Yield Mean Median 0.223 0.189 0.268 0.241 -0.045 <.0001 -0.052 <.0001

Panel B. Summary statistics of market-valued debt ratio across states GDP Growth Term Spread Default Spread Rate Mean Median Mean Median Mean Median 0.236 0.163 0.245 0.172 0.299 0.247 Good 0.317 0.259 0.305 0.255 0.324 0.269 Bad G vs. B p-value -0.081 <.0001 -0.095 <.0001 -0.060 <.0001 -0.082 <.0001 -0.025 <.0001 -0.022 <.0001

Dividend Yield Mean Median 0.223 0.148 0.307 0.248 -0.084 <.0001 -0.100 <.0001

Price-output Ratio Mean Median 0.328 0.290 0.272 0.184 0.056 <.0001 0.106 <.0001

Panel C. Percentage of over-leveraged firms across states GDP Growth Rate Term Spread Default Spread BD MD BD MD BD MD 41.70% 35.24% 43.16% 37.48% 44.76% 41.81% Good 43.39% 43.01% 43.57% 41.04% 43.29% 43.33% Bad

Dividend Yield BD MD 40.23% 34.03% 45.08% 43.73%

Price-output Ratio BD MD 44.69% 43.40% 42.71% 40.57%

35

G vs. B p-value

-1.69% 0.0001

-7.77% <.0001

-0.41% 0.3408

-3.56% <.0001

1.47% 0.0011

-1.52% 0.0006

-4.85% <.0001

-9.70% <.0001

1.98% <.0001

2.83% <.0001

36

Table 3 Regression results for adjustment speed estimates from the integrated dynamic partial adjustment capital structure model This table reports the results of estimating Equation (3): Di,t = (1- ) Di,t-1 + Xi,t-1 + Macrot-1 + i,t by controlling for firm fixed effects across good and bad states. Columns 2, 3 and 4 in each panel present the estimation results when the book-value debt ratio is used, computed as (long-term book debt + short-term book debt)/total book assets. Columns 5, 6, and 7 in each panel report the estimation results when market-value debt ratio is used, computed by (long-term book debt + short-term book debt)/(long-term book debt + short-term book debt + stock price* number of shares outstanding). The independent variables are as follows: CPG represents two-year aggregate domestic nonfinancial corporate profit growth, which is obtained from the Annual Flow of Funds database on the Federal Reserve website. VRMR represents the two-year value-weighted market return of stocks traded on NYSE/AMEX/NASDAQ, which is extracted from CRSP. CPSPREAD is the commercial paper spread, computed from the annualized rate of three-month commercial paper less the three-month Treasury bill. MB equals the ratio of market to book value. TANG equals the ratio of gross property, plant and equipment to total assets; EBIT is the ratio of earnings before interest and tax to total assets. DEP is depreciation expenses as a fraction of total assets. RDD is a dummy variable that takes the value of 1 if firms report R&D expenses and takes the value of 0, if otherwise. SE equals selling expenses scaled by net sales. LNTA is the natural log of total assets. RD IND_BD/MD is the median equals the ratio of R&D expenses to total assets. book/market debt ratio of the firms industry, where the industry categorization is based on the Fama and French 49 industry definition. LEVDUMMY takes the value of 1 if the firm is over-levered, defined as (Di,t-1 Di,t-1*) being greater than zero, and takes the value of 0, if otherwise. GOODDUMMY takes the value of 1 if the firm year observation belongs to a good state and the value of 0, if otherwise. We create interaction terms between the lagged debt ratio, the leverage dummy variable and the good state dummy variable. Panels A through E report the estimation results for the good, bad, and pooledstate sub-samples as defined by term spread, default spread, GDP growth rate, dividend yield, and price-output ratio. These five macroeconomic indicators define the good and bad states as follows: (1) Term spread is the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series. (2) Default spread is the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with Moodys rating of AAA. (3) GDP growth rate is defined as average real GDP growth rate over quarters in a year. (4) Dividend yield on the market equals total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. (5) Price-output ratio is the S&P stock price index in January in a given year scaled by GDP from the previous year. We divide the 30 years in the sample periods into macroeconomic quintiles based on each macroeconomic factor. Sorting by the term spread or GDP growth rate factor places years in the highest macroeconomic quintile -- good state (lowest macroeconomic quintile bad state) when the term spread and GDP growth rate are in the highest (lowest) quintile. Sorting by default spread, dividend yield or price-output ratio places years in the highest macroeconomic quintile -- good state (lowest quintile bad state) when

37

default spread, dividend yield or price-output ratio are in the lowest (highest) quintiles. We report coefficient estimates in the tables (t-statistics are in parenthesis) with *, **, and *** indicating significance at the 10%, 5%, and 1% levels, respectively. We also report the R-squared statistic and number of observations.
Panel A. Results from regressions when states are determined by term spread BD Good Bad G vs. B Good BDt-1/MDt-1 VRMR CPSPREAD CPG MB TANG EBIT DEP RD RDD SE LNTA IND_BD/MD LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.209 (24.21) 0.011 (3.10) -1.837 (-5.13) 0.002 (0.85) 0.000 (4.85) 0.070 (9.34) 0.003 (3.41) 0.019 (2.45) 0.000 (-1.11) -0.016 (-4.41) 0.000 (-0.10) 0.004 (3.60) 0.235 (9.51) 0.180 (56.47) 0.115 (10.90) *** *** *** 0.348 (38.96) -0.002 (-0.69) -0.265 (-2.38) -0.006 (-0.89) 0.000 (-0.26) 0.070 (9.29) -0.005 (-2.87) 0.035 (2.05) 0.000 (0.82) -0.016 (-5.51) 0.000 (0.65) 0.007 (6.59) 0.166 (8.25) 0.153 (43.96) 0.097 (8.82) *** 0.326 (53.61) 0.005 (2.13) -0.235 (-2.64) 0.002 (1.19) 0.000 (2.12) 0.074 (16.18) 0.000 (0.17) 0.003 (0.56) 0.000 (-0.01) -0.017 (-8.42) 0.000 (3.13) 0.005 (7.56) 0.214 (15.69) 0.168 (80.61) 0.110 (16.19) 0.008 (4.65) -0.051 (-11.63) Yes 25629 0.9041 Yes 25210 0.9177 Yes 50839 0.8793 *** ** *** 0.207 (28.75) 0.022 (5.71) -0.865 (-2.22) -0.001 (-0.18) 0.000 (0.21) 0.059 (7.67) 0.000 (0.91) 0.015 (2.82) 0.000 (-0.94) -0.021 (-5.60) 0.000 (0.88) 0.010 (8.72) 0.237 (12.40) 0.160 (48.11) 0.232 (26.48) *** *** ** MD Bad 0.315 (37.95) 0.005 (1.20) -0.337 (-2.48) -0.015 (-1.84) -0.001 (-8.02) 0.082 (9.37) -0.002 (-1.90) -0.008 (-0.62) 0.000 (0.21) -0.026 (-7.20) 0.000 (2.10) 0.012 (9.17) 0.081 (5.19) 0.190 (52.03) 0.166 (17.24) ***

G vs. B 0.319 (59.70) 0.016 (6.18) -0.155 (-1.52) -0.004 (-1.94) 0.000 (-2.28) 0.070 (13.91) 0.000 (2.25) 0.002 (2.42) 0.000 (-0.53) -0.025 (-11.05) 0.000 (4.37) 0.013 (17.68) 0.151 (15.63) 0.176 (81.38) 0.209 (36.49) 0.005 (2.79) -0.085 (-21.54) *** ***

**

** * *** *** *

* ** *** * **

*** *** *** **

** ***

*** *** **

***

***

***

***

*** *** *** *** *** *** *** ***

***

*** ** *** *** *** ***

*** *** *** *** *** *** *** ***

*** *** *** ***

*** *** *** ***

*** *** *** ***

Fix-effect Obs R-Square

Yes 26385 0.9145

Yes 25756 0.9285

Yes 52141 0.8993

38

Panel B. Results from regressions when states are determined by default spread BD Good Bad G vs. B Good BDt-1/MDt-1 VRMR CPSPREAD CPG MB TANG EBIT DEP RD RDD SE LNTA IND_BD/MD LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.170 (21.83) 0.034 (5.94) 0.773 (2.37) -0.012 (-1.78) 0.000 (-1.69) 0.081 (10.92) -0.004 (-2.69) 0.035 (2.80) 0.000 (-0.42) -0.006 (-1.58) 0.000 (0.94) 0.013 (9.56) 0.329 (11.47) 0.196 (74.80) 0.039 (4.24) *** *** ** * * *** *** *** 0.191 (20.97) 0.010 (2.68) -0.186 (-2.42) 0.008 (3.42) -0.001 (-3.19) 0.080 (10.03) -0.039 (-9.16) -0.040 (-7.51) 0.000 (0.90) -0.012 (-3.60) 0.000 (0.28) 0.022 (12.52) 0.207 (7.54) 0.162 (49.92) 0.103 (9.66) *** *** ** *** *** *** *** *** 0.282 (43.94) 0.024 (9.92) -0.091 (-1.27) 0.004 (1.73) -0.001 (-4.13) 0.080 (17.44) -0.005 (-4.29) -0.001 (-0.36) 0.000 (0.20) -0.013 (-6.25) 0.000 (0.79) 0.009 (12.08) 0.239 (15.62) 0.184 (95.25) 0.070 (10.69) 0.002 (0.91) -0.039 (-6.89) Yes 31226 0.8915 Yes 23407 0.8867 Yes 54633 0.8734 *** *** 0.131 (18.02) 0.022 (3.40) 0.776 (2.14) -0.055 (-7.27) 0.000 (-0.13) 0.079 (10.10) 0.000 (-1.99) 0.025 (2.84) 0.000 (1.31) -0.021 (-5.15) 0.000 (4.64) 0.026 (18.20) 0.265 (12.34) 0.181 (69.00) 0.222 (27.08) *** *** ** ***

MD Bad 0.202 (26.16) 0.062 (15.63) -0.755 (-7.98) 0.016 (5.71) -0.007 (-15.02) 0.083 (9.34) -0.016 (-5.91) 0.061 (3.08) 0.000 (0.72) -0.021 (-5.52) 0.000 (-0.73) 0.038 (19.04) 0.134 (9.24) 0.192 (57.81) 0.127 (14.73) *** *** *** *** *** *** *** ***

G vs. B 0.260 (45.92) 0.053 (19.00) -0.352 (-4.03) 0.007 (2.81) 0.000 (-3.40) 0.073 (14.54) 0.000 (-1.67) 0.024 (3.05) 0.000 (0.15) -0.019 (-8.58) 0.000 (3.50) 0.019 (22.93) 0.162 (14.50) 0.192 (97.96) 0.170 (30.01) -0.008 (-3.71) -0.010 (-1.99) *** *** *** *** *** *** * ***

* *** *** ***

*** ** ***

***

***

*** ** *** *** *** ***

***

*** *** *** *** *** *** *** **

*** *** *** ***

*** *** *** ***

*** *** *** ***

*** *** *** ***

*** Yes 31883 0.8997 Yes 23483 0.9092

Fix-effect Obs R-Square

Yes 55366 0.8913

39

Panel C. Results from regressions when states are determined by GDP growth rate BD Good Bad G vs. B Good BDt-1/MDt-1 VRMR CPSPREAD CPG MB TANG EBIT DEP RD RDD SE LNTA IND_BD/MD LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.267 (27.76) 0.017 (3.17) -0.734 (-1.86) 0.006 (1.08) 0.000 (0.22) 0.094 (12.18) 0.002 (0.88) 0.007 (2.60) 0.000 (0.27) -0.018 (-6.73) 0.000 (1.07) 0.006 (5.38) 0.167 (7.62) 0.171 (51.98) 0.047 (4.15) *** *** * 0.315 (34.32) -0.001 -(0.21) -0.475 (-4.48) 0.010 (1.84) 0.000 (-1.69) 0.067 (8.74) -0.007 (-3.63) 0.023 (0.97) 0.000 (-1.18) -0.020 (-6.98) 0.000 (0.03) 0.007 (6.11) 0.159 (7.50) 0.140 (38.25) 0.136 (11.91) *** 0.332 (52.79) 0.008 (3.56) -0.324 (-4.25) 0.003 (1.26) 0.000 (-2.26) 0.080 (16.67) -0.004 (-3.66) 0.001 (0.30) 0.000 (0.95) -0.018 (-9.73) 0.000 (1.05) 0.008 (11.57) 0.166 (12.21) 0.162 (74.44) 0.085 (11.95) 0.006 (4.05) -0.031 (-7.22) Yes 24952 0.9125 Yes 23848 0.9195 Yes 48800 0.8844 *** *** *** 0.250 (30.99) 0.022 (3.62) 2.665 (5.79) -0.019 (-2.61) 0.000 (-2.98) 0.081 (9.25) 0.000 (-0.40) -0.021 (-1.87) 0.000 (-1.62) -0.023 (-7.00) 0.000 (1.39) 0.013 (10.01) 0.117 (8.90) 0.191 (54.36) 0.139 (14.86) *** *** *** *** *** ***

MD Bad 0.323 (37.60) 0.035 (6.33) -0.570 (-4.44) 0.007 (1.03) -0.002 (-7.12) 0.085 (9.33) -0.012 (-7.00) 0.001 (0.03) 0.000 (0.33) -0.026 (-7.47) 0.000 (-0.47) 0.013 (9.55) 0.060 (3.78) 0.195 (48.97) 0.128 (12.79) *** *** ***

G vs. B 0.321 (57.76) 0.041 (14.52) 0.130 (1.45) 0.013 (3.82) -0.001 (-10.58) 0.089 (16.20) -0.001 (-4.78) -0.010 (-1.13) 0.000 (-0.72) -0.023 (-10.57) 0.000 (1.60) 0.015 (17.93) 0.106 (11.84) 0.195 (84.76) 0.143 (23.95) -0.005 (-2.60) -0.040 (-10.52) *** ***

*** * * *** ***

*** *** *** ***

** *** ***

*** *** ***

***

***

***

***

***

***

***

***

*** *** *** ***

*** *** *** ***

*** *** *** *** *** ***

*** *** *** ***

*** *** *** ***

*** *** *** *** *** ***

Fix-effect Obs R-Square

Yes 25398 0.9255

Yes 24181 0.9313

Yes 49579 0.9037

40

Panel D. Results from regressions when states are determined by dividend yield BD Good Bad G vs. B Good BDt-1/MDt-1 VRMR CPSPREAD CPG MB TANG EBIT DEP RD RDD SE LNTA IND_BD/MD LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY*LEVDUMMY*BDt-1/MDt-1 0.206 (26.14) 0.001 (0.37) 1.320 (2.72) 0.004 (1.35) 0.000 (5.22) 0.073 (9.99) 0.003 (3.74) 0.020 (2.80) 0.000 (-1.11) -0.021 (-5.76) 0.000 (-0.71) 0.004 (3.45) 0.271 (10.87) 0.179 (59.03) 0.097 (9.82) *** 0.284 (30.30) 0.015 (2.41) -0.121 (-1.14) 0.004 (0.93) 0.000 (-0.45) 0.059 (7.87) -0.008 (-3.82) -0.006 (-0.32) 0.000 (-2.90) -0.014 (-3.85) 0.000 (2.46) 0.004 (3.38) 0.194 (8.20) 0.172 (50.76) 0.124 (11.12) *** ** 0.311 (44.73) 0.006 (2.21) -0.071 (-0.84) 0.003 (1.30) 0.000 (1.02) 0.067 (14.78) -0.001 (-0.94) -0.004 (-0.59) 0.000 (-1.99) -0.017 (-7.92) 0.000 (2.46) 0.003 (5.03) 0.211 (14.46) 0.173 (85.04) 0.111 (14.44) 0.004 (2.39) -0.072 (-8.62) 0.011 (1.43) Yes 25474 0.9001 Yes 51676 0.8764 Yes 26888 0.9125 *** ** 0.191 (28.96) 0.013 (3.74) 2.177 (4.23) -0.006 (-1.64) 0.000 (0.19) 0.051 (6.87) 0.000 (0.87) 0.016 (3.24) 0.000 (-0.36) -0.028 (-7.42) 0.000 (0.38) 0.011 (10.23) 0.204 (12.09) 0.155 (51.95) 0.227 (28.32) *** *** ***

MD Bad 0.283 (31.90) 0.080 (11.46) -0.516 (-4.13) 0.003 (0.53) -0.001 (-3.74) 0.049 (5.72) -0.006 (-3.44) 0.065 (3.22) 0.000 (0.63) -0.021 (-5.30) 0.000 (2.94) 0.017 (11.98) 0.210 (12.29) 0.190 (53.87) 0.194 (19.42) *** *** ***

G vs. B 0.294 (46.20) 0.031 (10.60) -0.414 (-4.34) -0.011 (-4.63) 0.000 (-2.40) 0.054 (11.13) 0.000 (1.89) 0.002 (1.78) 0.000 (-0.58) -0.023 (-9.81) 0.000 (3.23) 0.013 (18.56) 0.168 (15.95) 0.170 (82.40) 0.231 (33.86) 0.003 (1.69) -0.067 (-8.96) -0.016 (-2.33) *** *** *** *** ** *** * *

***

*** *** *** ***

*** *** *** ***

*** ***

***

***

***

*** *** ** *** *** *** ***

** *** ** *** *** *** *** ** ***

***

***

*** *** *** *** *** ***

*** *** *** *** *** *** * *** **

*** *** *** ***

*** *** *** ***

Fix-effect Obs R-Square

Yes 26202 0.8994

Yes 25774 0.9178

Yes 52662 0.8965

41

Panel E. Results from regressions when states are determined by Price-output ratio BD Good Bad G vs. B Good BDt-1/MDt-1 VRMR CPSPREAD CPG MB TANG EBIT DEP RD RDD SE LNTA IND_BD/MD LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY*LEVDUMMY*BDt-1/MDt-1 0.248 (25.59) -0.006 (-0.71) -0.736 (-6.72) 0.023 (6.45) -0.003 (-3.75) 0.085 (9.89) -0.050 (-9.46) -0.092 (-3.44) -0.001 (-0.79) -0.014 (-5.46) 0.000 (-0.13) 0.016 (9.07) 0.158 (6.60) 0.134 (39.04) 0.105 (9.34) *** 0.128 (17.00) 0.004 (1.83) -0.832 (-1.64) -0.006 (-1.37) -0.001 (-6.80) 0.086 (11.24) -0.003 (-4.18) -0.009 (-1.49) 0.000 (-0.28) -0.016 (-4.15) 0.000 (1.31) 0.004 (3.48) 0.279 (11.62) 0.193 (69.26) 0.101 (11.25) *** * 0.174 (26.76) 0.006 (3.31) -0.342 (-3.82) 0.002 (0.88) -0.001 (-8.45) 0.086 (17.56) -0.004 (-4.91) -0.010 (-1.73) 0.000 (-0.07) -0.016 (-8.15) 0.000 (1.06) 0.004 (5.84) 0.234 (17.60) 0.177 (85.15) 0.146 (19.84) -0.027 (-10.96) 0.199 (20.82) -0.153 (-19.19) Yes 30746 0.8916 Yes 51978 0.8804 *** *** *** 0.225 (27.37) -0.045 (-4.84) -2.383 (-18.39) 0.082 (19.40) -0.006 (-8.31) 0.097 (9.80) -0.040 (-7.29) -0.007 (-0.26) 0.000 (0.25) -0.017 (-5.61) 0.000 (1.73) 0.036 (17.42) 0.208 (15.12) 0.174 (44.67) 0.121 (13.16) *** *** *** *** *** *** ***

MD Bad 0.069 (9.80) 0.012 (4.92) 1.367 (2.30) -0.061 (-11.92) 0.000 (-1.42) 0.093 (11.42) 0.000 (-0.39) 0.023 (5.61) 0.000 (-0.59) -0.020 (-4.49) 0.000 (2.15) 0.024 (18.08) 0.221 (13.89) 0.179 (63.92) 0.282 (35.72) *** *** ** ***

G vs. B 0.144 (23.45) 0.010 (4.52) -0.702 (-6.53) -0.001 (-0.31) 0.000 (-2.25) 0.083 (15.13) 0.000 (-0.22) 0.016 (4.14) 0.000 (-0.46) -0.020 (-8.44) 0.000 (2.41) 0.016 (18.92) 0.234 (23.60) 0.190 (86.98) 0.282 (41.61) -0.030 (-10.43) 0.159 (18.71) -0.183 (-25.29) *** *** ***

*** *** *** *** *** ***

*** *** ***

*** *** *** *

** ***

***

***

***

***

***

***

*** * *** *** *** ***

*** ** *** *** *** ***

*** ** *** *** *** *** *** *** ***

*** *** *** ***

*** *** *** ***

*** *** *** *** *** *** ***

Fix-effect Obs R-Square

Yes 21232 0.8951

Yes 21303 0.9157

Yes 32282 0.9012

Yes 53585 0.8961

42

Table 4 Regression results for adjustment speed estimates from a two-stage dynamic partial adjustment capital structure model This table reports the results of estimating a two stage model pertaining to Equations (1) and (2). We estimate the first-stage using QMLE by Papke and Wooldrige (1996) and the second-stage using standard OLS with t-statistics reflecting a standard error correction for heteroskedasticity. This table reports only the results from the secondstage. Columns 2, 3 and 4 in each panel present the estimation results when book-value debt ratio is used, computed as (long-term book debt + short-term book debt)/total book assets. Columns 5, 6, and 7 in each sub-table report the estimation results when marketvalue debt ratio is used, computed by (long-term book debt + short-term book debt)/(long-term book debt + short-term book debt + stock price* number of shares outstanding). The independent variables in the second-stage are: BDt-1/MDt-1 is the lagged value of debt ratio, BDt* equals the target debt ratio obtained as the fitted value from the first-stage regression. LEVDUMMY takes the value of 1 if the firm is overlevered, defined as (Di,t-1 Di,t-1*) being greater than zero, and takes the value of 0, if otherwise. GOODDUMMY takes the value of 1 if the firm year observation belongs to a good state and the value of 0, if otherwise. We create interaction terms between the lagged debt ratio, the leverage dummy variable and the good state dummy variable. Panels A through E report the estimation results for the good, bad, and pooled-state subsamples as defined by term spread, default spread, dividend yield, GDP growth rate and price-output ratio. These five macroeconomic indicators define the good and bad states as follows: (1) Term spread is the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series. (2) Default spread is the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with Moodys rating of AAA. (3) GDP growth rate is defined as average real GDP growth rate over quarters in a year. (4) Dividend yield on the market equals total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. (5) Price-output ratio is the S&P stock price index in January in a given year scaled by GDP from the previous year. We divide the 30 years in the sample periods into macroeconomic quintiles based on each macroeconomic factor. Sorting by the term spread or GDP growth rate factor places years in the highest macroeconomic quintile -- good state (lowest macroeconomic quintile bad state) when the term spread and GDP growth rate are in the highest (lowest) quintile. Sorting by default spread, dividend yield or price-output ratio places years in the highest macroeconomic quintile -- good state (lowest quintile bad state) when default spread, dividend yield or price-output ratio are in the lowest (highest) quintile. We report coefficient estimates in the tables (t-statistics are in parenthesis) with *, **, and *** indicating significance at the 10%, 5%, and 1% levels, respectively. We also report the R-squared statistic and number of observations.

43

Panel A. Results from regressions when states are determined by term spread BD Good Bad G vs. B Good CONSTANT -0.051 -0.045 -0.050 -0.038 (-24.44) *** (-19.85) *** (-27.15) *** (-23.54) BDt-1/MDt-1 BD*/MD* LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 -0.627 (-59.95) 0.447 (39.21) 0.170 (46.55) 0.145 (11.34) *** *** *** *** -0.537 (-52.64) 0.393 (35.11) 0.168 (44.40) 0.085 (6.89) *** *** *** *** -0.570 (-72.84) 0.421 (52.01) 0.170 (64.64) 0.112 (12.61) 0.002 (1.38) -0.023 (-4.15) 25629 0.4564 25210 0.406 50839 0.4315 *** *** *** *** -0.634 (-82.23) 0.388 (44.47) 0.163 (49.59) 0.226 (24.10)

*** *** *** *** ***

MD Bad -0.046 (-23.17) *** -0.580 (-68.26) 0.362 (42.87) 0.212 (65.51) 0.158 (17.19) *** *** *** ***

G vs. B -0.039 (-24.84) -0.571 (-91.32) 0.351 (59.42) 0.186 (79.19) 0.192 (29.02) 0.002 (1.56) -0.054 (-12.27)

*** *** *** *** ***

*** 26385 0.5004 25756 0.4782

***

Obs R-Square

52141 0.4874

Panel B. Results from regressions when states are determined by default spread BD Good Bad G vs. B Good CONSTANT -0.041 -0.034 -0.040 -0.034 (-24.56) *** (-11.19) *** (-22.01) *** (-26.50) BDt-1/MDt-1 BD*/MD* LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 -0.597 (-64.87) 0.400 (43.99) 0.180 (58.62) 0.104 (9.48) *** *** *** *** -0.543 (-53.03) 0.365 (27.70) 0.173 (47.29) 0.068 (5.38) *** *** *** *** -0.577 (-76.96) 0.403 (53.80) 0.178 (75.94) 0.087 (10.54) -0.004 (-2.80) 0.002 (0.43) 31226 0.4484 23407 0.4318 54633 0.4426 31883 0.5103 *** *** *** *** *** -0.662 (-84.42) 0.389 (53.33) 0.201 (75.07) 0.215 (24.13)

*** *** *** *** ***

MD Bad -0.018 (-10.31) *** -0.574 (-68.43) 0.307 (36.07) 0.204 (64.22) 0.106 (12.01) *** *** *** ***

G vs. B -0.033 (-23.15) -0.628 (-102.41) 0.375 (64.71) 0.205 (100.58) 0.159 (25.39) -0.002 (-1.72) -0.010 (-2.22)

*** *** *** *** *** * **

Obs R-Square

23483 0.494

55366 0.5029

44

Panel C. Results from regressions when states are determined by GDP growth rate BD Good Bad G vs. B Good CONSTANT -0.046 -0.043 -0.047 -0.028 (-18.10) *** (-16.32) *** (-24.48) *** (-17.56) BDt-1/MDt-1 BD*/MD* LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 -0.543 (-50.41) 0.405 (33.40) 0.163 (46.61) 0.083 (6.62) *** *** *** *** -0.526 (-49.72) 0.376 (30.52) 0.158 (38.90) 0.098 (7.55) *** *** *** *** -0.528 (-65.76) 0.397 (47.15) 0.161 (60.64) 0.091 (10.15) 0.002 (1.55) -0.015 (-2.78) 24952 0.4096 23848 0.3863 48800 0.3991 *** *** *** *** -0.597 (-73.70) 0.336 (43.64) 0.209 (67.76) 0.131 (14.67)

*** *** *** *** ***

MD Bad -0.031 (-15.64) *** -0.578 (-65.04) 0.316 (36.46) 0.210 (60.79) 0.140 (14.87) *** *** *** ***

G vs. B -0.031 (-19.84) -0.566 (-86.36) 0.312 (50.80) 0.209 (90.18) 0.134 (20.34) 0.002 (1.57) -0.029 (-7.10)

*** *** *** *** ***

*** 25398 0.5011 24177 0.4616

***

Obs R-Square

49575 0.4736

Panel D. Results from regressions when states are determined by dividend yield BD Good Bad G vs. B Good CONSTANT -0.043 -0.049 -0.041 -0.030 (-22.310 ** (-18.87) *** (-21.30) *** (-20.55) BDt-1/MDt-1 BD*/MD* LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY*LEVDUMMY*BDt-1/MDt-1 -0.614 (-59.82) 0.408 (36.24) 0.159 (43.09) 0.147 (11.68) *** *** *** *** -0.586 (-54.27) 0.415 (35.04) 0.184 (50.63) 0.107 (8.33) *** *** *** *** -0.601 (-60.94) 0.409 (50.97) 0.172 (66.42) 0.142 (13.61) -0.007 (-4.55) -0.003 (-0.27) -0.026 (-2.44) 25474 0.4366 51676 0.4449 ** 26888 0.5039 *** *** *** *** *** -0.631 (-86.37) 0.350 (41.09) 0.153 (48.99) 0.237 (26.48)

*** *** *** *** ***

MD Bad -0.051 (-22.89) *** -0.608 (-66.17) 0.396 (42.35) 0.213 (67.40) 0.172 (17.51) *** *** *** ***

G vs. B -0.029 (-18.87) -0.605 (-72.77) 0.347 (58.44) 0.182 (80.92) 0.224 (26.66) -0.009 (-6.97) -0.011 (-1.12) -0.044 (-4.77)

*** *** *** *** *** ***

***

Obs R-Square

26202 0.4455

25774 0.4817

52662 0.4962

45

Panel E. Results from regressions when states are determined by price-output ratio BD Good Bad G vs. B Good CONSTANT -0.027 -0.046 -0.047 -0.007 (-8.15) ** (-28.64) *** (-32.23) *** (-3.68) BDt-1/MDt-1 BD*/MD* LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY*LEVDUMMY*BDt-1/MDt-1 -0.491 (-45.27) 0.327 (23.45) 0.141 (36.68) 0.070 (5.26) *** *** *** *** -0.630 (-68.91) 0.416 (46.46) 0.182 (53.56) 0.143 (12.82) *** *** *** *** -0.636 (-73.61) 0.425 (56.27) 0.171 (65.95) 0.169 (17.71) -0.011 (-6.68) 0.154 (12.85) -0.158 (-16.13) 30746 0.451 51978 0.4308 *** *** *** *** *** *** *** 21303 0.463 -0.553 (-67.23) 0.256 (31.78) 0.180 (47.83) 0.107 (11.36) *** *** *** ***

MD Bad -0.044 (-31.17) *** -0.671 (-89.68) 0.384 (56.18) 0.206 (73.76) 0.260 (30.72) *** *** *** ***

G vs. B -0.044 (-34.84) -0.672 (-94.00) 0.386 (67.68) 0.205 (90.57) 0.265 (34.32) -0.015 (-9.94) 0.133 (14.45) -0.188 (-22.72)

*** *** *** *** *** *** *** ***

Obs R-Square

21232 0.3834

32282 0.5046

53585 0.4983

46

Table 5 Robustness check of boundary issue using the integrated dynamic partial adjustment model This table reports the results from re-estimating Equation (3) using the integrated dynamic partial adjustment model but omitting the zero-debt issuance firm-year observations. Panels A through E report the key estimation results for the good, bad, and pooled-state subsamples defined by term spread, default spread, dividend yield, GDP growth rate and price-output ratio. We report coefficient estimates for only the key regressors including the lagged value of debt ratio (BDi,t-1/MDi,t-1), LEVDUMMY which takes the value of 1 if the firm year observation is defined as over-levered and the value of 0, if otherwise, the interaction term between LEVDUMMY and the lagged debt ratio (LEVDUMMY * BDi,t-1/MDi,t-1), Good dummy which takes the value of 1 if the firm year observation belongs to a good state and the value of 0, if otherwise, and the interaction term between the lagged debt ratio and good dummy variable: (GOODDUMMY* BDi,t1/MDi,t-1). In panels D and E, we also report the interaction term between the leverage dummy variable, good dummy variable, and the lagged debt ratio (GOODDUMMY* LEVDUMMY * BDi,t-1/MDi,t-1). The five macroeconomic indicators used to define the good and bad states as follows: (1) Term spread is the difference between the twentyyear government bond yield series and the three-month Treasury-bill rate series. (2) Default spread is the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with Moodys rating of AAA. (3) GDP growth rate is defined as average real GDP growth rate over quarters in a year. (4) Dividend yield on the market equals total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. (5) Price-output ratio is the S&P stock price index in January in a given year scaled by GDP from the previous year. We divide the 30 years in the sample periods into macroeconomic quintiles based on each macroeconomic factor. Sorting by the term spread or GDP growth rate factor places years in the highest macroeconomic quintile -good state (lowest macroeconomic quintile bad state) when term spread and GDP growth rate are in the highest (lowest) quintile. Sorting by default spread, dividend yield or price-output ratio places years in the highest macroeconomic quintile -- good state (lowest quintile bad state) when default spread, dividend yield or price-output ratio are in the lowest (highest) quintile. Coefficient estimates are reported in the tables (with tstatistics in parenthesis) *, **, and *** indicate significance at 10%, 5%, and 1% level, respectively. We report the R-squared statistic and number of observations.

47

Panel A. Regression results when states are determined by term spread BD Good Bad G vs. B BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.212 (20.75) 0.168 (47.17) 0.109 (9.03) *** *** *** 0.322 (32.87) 0.135 (37.06) 0.124 (10.61) *** *** *** 0.313 (45.54) 0.153 (67.83) 0.123 (16.54) 0.008 (3.88) -0.050 (-10.00) Yes 22288 0.8952 Yes 22935 0.9139 Yes 45223 0.8692 *** *** *** *** ***

Good 0.208 (25.32) 0.155 (42.61) 0.216 (22.30) *** *** ***

MD Bad 0.314 (34.49) 0.185 (47.58) 0.158 (15.25) *** *** ***

G vs. B 0.323 (54.46) 0.170 (72.93) 0.199 (31.94) 0.004 (1.99) -0.084 (-18.97) *** *** *** ** ***

Fix effect Obs R-Square

Yes 23075 0.9098

Yes 23476 0.9250

Yes 46551 0.8928

Panel B. Regression results when states are determined by default spread BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.138 (15.70) 0.175 (60.67) 0.064 (6.44) *** *** *** 0.177 (18.01) 0.150 (44.64) 0.109 (9.70) *** *** *** 0.263 (37.34) 0.168 (81.09) 0.089 (12.51) 0.005 (2.11) -0.045 (-7.41) Yes 27501 0.8823 Yes 21839 0.8818 Yes 49340 0.8639 *** *** *** ** *** Yes 28155 0.8940 0.125 (15.47) 0.173 (60.62) 0.214 (23.95) *** *** ***

MD Bad 0.204 (24.92) 0.189 (54.98) 0.114 (12.73) *** *** ***

G vs. B 0.258 (41.98) 0.186 (89.24) 0.162 (26.76) -0.008 (-3.55) -0.007 (-1.20) *** *** *** ***

Fix effect Obs R-Square

Yes 21944 0.9059

Yes 50099 0.8851

48

Panel C. Regression results when states are determined by GDP growth rate BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 0.259 (24.60) 0.155 (44.13) 0.062 (5.11) *** *** *** 0.288 (28.63) 0.127 (32.97) 0.159 (13.08) *** *** *** 0.308 (44.84) 0.145 (63.57) 0.108 (14.29) 0.007 (4.19) -0.034 (-7.15) Yes 22750 0.9074 Yes 21835 0.9138 Yes 44585 0.8776 *** *** *** *** *** Yes 23200 0.9219 0.252 (29.24) 0.183 (49.50) 0.136 (13.79) *** *** ***

MD Bad 0.316 (34.18) 0.190 (45.80) 0.121 (11.47) *** *** ***

G vs. B 0.318 (53.01) 0.187 (77.50) 0.140 (22.14) -0.004 (-2.21) -0.042 (-10.19) *** *** *** ** ***

Fix effect Obs R-Square

Yes 22178 0.9283

Yes 45378 0.8984

Panel D. Regression results when states are determined by dividend yield BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY* LEVDUMMY*BDt-1/MDt-1 0.201 (21.53) 0.162 (48.03) 0.103 (9.20) *** *** *** 0.283 (27.25) 0.160 (44.86) 0.125 (10.36) *** *** *** 0.304 (38.37) 0.159 (71.89) 0.119 (14.20) 0.003 (1.74) -0.067 (-7.05) 0.006 (0.76) Yes 23240 0.8937 Yes 45741 0.8653 Yes 23217 0.9076 *** *** *** * *** 0.180 (24.13) 0.148 (45.04) 0.220 (24.78) *** *** ***

MD Bad 0.306 (31.63) 0.185 (49.98) 0.168 (15.69) *** *** ***

G vs. B 0.307 (42.98) 0.164 (73.47) 0.213 (28.53) 0.004 (1.88) -0.079 (-9.40) -0.005 (-0.68) *** *** *** * ***

Fix effect Obs R-Square

Yes 22501 0.8897

Yes 23574 0.9148

Yes 46791 0.8905

49

Panel E. Regression results when states are determined by price-output ratio BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY*BDt-1/MDt-1 GOODDUMMY* LEVDUMMY*BDt-1/MDt-1 0.229 (22.41) 0.124 (35.21) 0.116 (9.88) *** *** *** 0.107 (12.33) 0.170 (55.02) 0.124 (12.43) *** *** *** 0.156 (21.20) 0.158 (70.85) 0.162 (20.30) -0.031 (-11.15) 0.187 (17.99) -0.130 (-15.67) Yes 26554 0.8814 Yes 46551 0.8708 *** *** *** *** *** *** Yes 20078 0.9124 0.223 (25.93) 0.171 (43.10) 0.110 (11.58) *** *** ***

MD Bad 0.076 (9.41) 0.170 (55.08) 0.264 (30.10) *** *** ***

G vs. B 0.154 (22.38) 0.183 (77.65) 0.263 (35.80) -0.031 (-9.37) 0.139 (15.03) -0.162 (-21.14) *** *** *** *** *** ***

Fix effect Obs R-Square

Yes 19997 0.8899

Yes 28052 0.8946

Yes 48130 0.8887

50

Table 6 Robustness check of boundary issue using the two-stage dynamic partial adjustment model This table reports the results from re-estimating Equations (1) and (2) using a two-stage dynamic partial adjustment model but omitting the zero-debt issuance firm-year observations. Panels A through E report the key estimation results for the good, bad, and pooled-state subsamples defined by term spread, default spread, dividend yield, GDP growth rate and price-output ratio. We report coefficient estimates for only the key regressors including the lagged value of debt ratio (BDi,t-1/MDi,t-1), LEVDUMMY which takes the value of 1 if the firm year observation is defined as over-levered and the value of 0, if otherwise, the interaction term between LEVDUMMY and the lagged debt ratio (LEVDUMMY * BDi,t-1/MDi,t-1), Good dummy which takes the value of 1 if the firm year observation belongs to a good state and the value of 0, if otherwise, and the interaction term between the lagged debt ratio and good dummy variable: (GOODDUMMY* BDi,t1/MDi,t-1). In panels D and E, we also report the interaction term between the leverage dummy variable, good dummy variable, and the lagged debt ratio (GOODDUMMY* LEVDUMMY * BDi,t-1/MDi,t-1). The five macroeconomic indicators used to define the good and bad states as follows: (1) Term spread is the difference between the twentyyear government bond yield series and the three-month Treasury-bill rate series. (2) Default spread is the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with Moodys rating of AAA. (3) GDP growth rate is defined as average real GDP growth rate over quarters in a year. (4) Dividend yield on the market equals total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. (5) Price-output ratio is the S&P stock price index in January in a given year scaled by GDP from the previous year. We divide the 30 years in the sample periods into macroeconomic quintiles based on each macroeconomic factor. Sorting by the term spread or GDP growth rate factor places years in the highest macroeconomic quintile -good state (lowest macroeconomic quintile bad state) when term spread and GDP growth rate are in the highest (lowest) quintile. Sorting by default spread, dividend yield or price-output ratio places years in the highest macroeconomic quintile -- good state (lowest quintile bad state) when default spread, dividend yield or price-output ratio are in the lowest (highest) quintile. Coefficient estimates are reported in the tables (with tstatistics in parenthesis) *, **, and *** indicate significance at 10%, 5%, and 1% level, respectively. We report the R-squared statistic and number of observations.

51

Panel A. Regression results when states are determined by term spread BD Good Bad G vs. B BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY *BDt-1/MDt-1 -0.642 (-59.30) 0.155 (41.50) 0.159 (12.14) *** *** *** -0.563 (-54.87) 0.153 (39.72) 0.110 (8.83) *** *** *** -0.591 (-73.33) 0.155 (57.67) 0.133 (14.65) 0.000 (-0.24) -0.022 (-3.51) 22288 0.4462 22935 0.4069 45223 0.4268 *** *** ***

Good -0.643 (-86.98) 0.151 (45.21) 0.235 (25.66) *** *** ***

MD Bad -0.594 (-73.53) 0.201 (62.02) 0.165 (18.77) *** *** ***

G vs. B -0.583 (-96.84) 0.174 (73.16) 0.201 (31.30) 0.000 (0.03) -0.051 (-10.94) *** *** ***

*** 23075 0.4931 23476 0.4768

***

Obs R-Square

46551 0.4829

Panel B. Regression results when states are determined by default spread BD Good Bad G vs. B BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY *BDt-1/MDt-1 -0.633 (-67.33) 0.164 (52.55) 0.136 (12.24) *** *** *** -0.577 (-57.85) 0.157 (42.77) 0.099 (8.02) *** *** *** -0.610 (-81.09) 0.163 (68.19) 0.118 (14.31) -0.005 (-3.00) 0.002 (0.39) 27501 0.4513 21839 0.4396 49340 0.4471 *** *** *** ***

Good -0.698 (-92.21) 0.188 (70.94) 0.238 (27.82) *** *** ***

MD Bad -0.608 (-75.54) 0.193 (60.94) 0.130 (15.40) *** *** ***

G vs. B -0.663 (-112.93) 0.194 (95.68) 0.181 (30.48) -0.002 (-1.83) -0.013 (-2.82) *** *** *** * ***

Obs R-Square

28155 0.5140

21944 0.5034

50099 0.5112

52

Panel C. Regression results when states are determined by GDP growth rate BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY *BDt-1/MDt-1 -0.576 (-52.71) 0.148 (41.36) 0.114 (8.88) *** *** *** -0.557 (-51.29) 0.142 (34.51) 0.128 (9.65) *** *** *** -0.560 (-67.63) 0.146 (53.98) 0.121 (13.29) 0.001 (0.48) -0.015 (-2.53) 22750 0.4159 21835 0.3888 44585 0.4029 *** *** *** -0.629 (-79.09) 0.196 (63.44) 0.154 (17.61) *** *** ***

MD Bad -0.579 (-72.90) 0.202 (57.51) 0.145 (16.39) *** *** ***

G vs. B -0.607 (-96.38) 0.196 (84.47) 0.160 (25.52) 0.002 (1.31) -0.030 (-7.01) *** *** ***

** 23200 0.5079 22176 0.4655

***

Obs R-Square

45376 0.4829

Panel D. Regression results when states are determined by dividend yield BD Good Bad G vs. B BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY *BDt-1/MDt-1 GOODDUMMY* LEVDUMMY*BDt-1/MDt-1 -0.631 (-59.69) 0.144 (38.18) 0.164 (12.73) *** *** *** -0.608 (-55.91) 0.168 (45.42) 0.129 (9.92) *** *** *** -0.626 (-62.99) 0.156 (59.35) 0.164 (15.87) -0.010 (-4.98) 0.009 (0.67) -0.033 (-3.16) 23240 0.4345 45741 0.4394 *** *** *** *** ***

Good -0.647 (-89.93) 0.140 (44.12) 0.253 (28.43) *** *** ***

MD Bad -0.638 (-72.92) 0.201 (64.20) 0.181 (19.63) *** *** ***

G vs. B -0.610 (-82.49) 0.171 (74.96) 0.227 (29.93) -0.011 (-6.57) -0.017 (-1.84) -0.034 (-4.06) *** *** *** *** * ***

Obs R-Square

22501 0.4348

23217 0.4990

23574 0.4745

46791 0.4922

53

Panel E. Regression results when states are determined by price-output ratio BD Good Bad G vs. B Good BDt-1/MDt-1 LEVDUMMY LEVDUMMY*BDt-1/MDt-1 GOODDUMMY GOODDUMMY *BDt-1/MDt-1 GOODDUMMY* LEVDUMMY*BDt-1/MDt-1 -0.532 (-49.02) 0.126 (32.74) 0.106 (7.98) *** *** *** -0.649 (-67.07) 0.167 (48.07) 0.160 (13.88) *** *** *** -0.658 (-72.47) 0.155 (59.18) 0.188 (19.34) -0.011 (-5.77) 0.145 (11.74) -0.142 (-14.98) 26554 0.4404 46551 0.4267 *** *** *** *** *** *** 20078 0.4733 -0.588 (-74.16) 0.168 (44.57) 0.132 (14.61) *** *** ***

MD Bad -0.678 (-92.65) 0.194 (68.29) 0.263 (31.56) *** *** ***

G vs. B -0.681 (-97.77) 0.193 (84.77) 0.268 (35.74) -0.015 (-8.74) 0.119 (13.50) -0.170 (-22.10) *** *** *** *** *** ***

Obs R-Square

19997 0.3968

28052 0.4935

48130 0.4942

54

Table 7 Robustness check on firm size impact This table analyzes the firm size impact across good and bad states over the sample period from 1976 to 2005. We measure firm size as the logarithm of total assets (LNTA). We report mean differences in firm size across good and bad states for debt ratios measured on both a book- and market-value basis. The book- and market- value debt ratios are as follows: BD is the book-value debt ratio computed by (long-term book debt + short-term book debt)/total book assets, MD is the market-value debt ratio computed by (longterm book debt + short-term book debt)/(long-term book debt + short-term book debt + stock price* number of shares outstanding). Column 2 and 3 examine the mean difference in LNTA between good and bad states as defined by term spread, which is the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series. Columns 4 and 5 analyze the mean difference in LNTA between good and bad states as defined by default spread, which is the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with a Moodys rating of AAA. Columns 6 and 7 examine the mean difference in LNTA between good and bad states as defined by GDP growth rate, which is the average real GDP growth rate over quarters in a year. Columns 8 and 9 examine the mean difference in LNTA between good and bad states as defined by dividend yield on the market, measured as total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. Columns 10 and 11 analyze the mean difference in LNTA between good and bad states as defined by price-output ratio, computed as the S&P stock price index in January in a given year scaled by GDP from the previous year.
Term Spread LNTA-BD LNTA-MD 18.456 18.334 18.374 18.299 0.082 <.0001 0.035 0.104 Default Spread LNTA-BD LNTA-MD 18.388 18.107 18.122 18.331 0.266 <.0001 -0.224 <.0001 GDP Growth Rate LNTA-BD LNTA-MD 18.290 18.238 18.458 18.403 -0.168 <.0001 -0.165 <.0001 Dividend Yield LNTA-BD LNTA-MD 18.512 18.402 18.131 18.087 0.381 <.0001 0.315 <.0001 Price-output Ratio LNTA-BD LNTA-MD 18.394 18.380 18.550 18.375 -0.156 <.0001 0.005 0.792

Good Bad G vs. B p-value

55

Table 8 Robustness check of the distance of actual debt ratio deviation from target This table analyzes the distance between actual and target debt ratios across good and bad states over the sample period from 1976 to 2005. We measure the distance as: DISi,t = D i, t * - D i, t , where Di,t*= Macrot-1 + Xi,t-1, Macro is a set of macroeconomic target variables, and X is the vector of firm characteristics determining the target debt level. The debt ratios are book- and market-value debt ratios defined as follows: BD is the book-value debt ratio calculated as (long-term book debt + short-term debt)/total book assets. MD is the market-value debt ratio computed as (long-term book debt + short-term book debt)/(long-term book debt + short-term book debt + stock price* number of shares outstanding), Columns 2 and 3 show the mean difference in DIS between good and bad states as defined by term spread, measured as the difference between the twenty-year government bond yield series and the three-month Treasury-bill rate series. Columns 4 and 5 report the mean difference in DIS between good and bad states as defined by default spread, the difference between the average yield of bonds rated BAA by Moodys and the average yield of bonds with a Moodys rating of AAA. Columns 6 and 7 examine the mean difference in DIS between good and bad states defined by GDP growth rate, average real GDP growth rate over quarters in a year. Columns 8 and 9 in DIS illustrate the mean difference between good and bad states as defined by dividend yield on the market, measured as total dividend payments on the value-weighted NYSE/AMEX/Nasdaq portfolio over year t-1 divided by the current value of the portfolio at time t. Columns 10 and 11 report the mean difference in DIS between good and bad states as defined by price-output ratio, computed as the S&P stock price index in January in a given year scaled by GDP from the previous year..
Term Spread DIS-BD DIS-MD 0.154 0.170 0.155 0.193 -0.002 0.1684 -0.024 <.0001 Default Spread DIS-BD DIS-MD 0.154 0.170 0.152 0.181 0.003 0.008 -0.011 <.0001 GDP Growth Rate DIS-BD DIS-MD 0.150 0.184 0.156 0.196 -0.005 <.0001 -0.012 <.0001 Dividend Yield DIS-BD DIS-MD 0.152 0.167 0.161 0.190 -0.009 <.0001 -0.023 <.0001 Price-output Ratio DIS-BD DIS-MD 0.143 0.190 0.161 0.183 -0.018 <.0001 0.007 <.0001

Good Bad G vs. B p-value

56