Sensitivity to Target Leverage Deviation and its Effect on Speed of Adjustment - A Study of Capital Structure Adjustments in a Nordic Context

Abstract: In this paper, we study whether cost of equity is sensitive to deviations from target leverage and if this sensitivity is an explanatory factor for firms' speed of adjustment (SOA) towards an optimal capital structure. Further, we explore if access to bond markets could influence SOA. The study is made using a balanced panel of quarterly observations for 142 Nordic listed firms from 2007 to 2015. We construct a cost of equity measure based on a set of five valuation methods, and estimate target leverage using well-established leverage determinants. This allows us to test if there is a sensitivity of cost of equity to target leverage deviation. Next, we determine whether this sensitivity can explain the SOA by constructing a sensitivity measure based on a direct approach. The results of our study indicate that the cost of equity is not sensitive to target leverage deviation in a Nordic context. Consequently, we find that sensitivity of cost of equity to target leverage deviation cannot explain a firm's SOA. Finally, we find that the SOA of Nordic listed firms is lower compared to studies made on U.S. data. In spite of different access to bond markets for Nordic and U.S. firms, the usage of bonds as a proxy for a more market-based capital structure cannot be shown to be a driver of SOA in a Nordic setting.