Firm Financial Behaviour Dynamics and Interactions: Is Leverage Residually Determined?

This thesis investigates the dynamics and interactions of firm financial behaviours, with a focus on capital structure (leverage) decisions. The thesis is composed of three empirical chapters, after a review of the literature in Chapter 2. Chapter 3 of the thesis uses a five-variable Structural Vector Autoregression (SVAR) framework to investigate the dynamics and interactions of firm financial behaviours (i.e., investment, dividend, leverage, equity issuance and profitability). The results show that the aforementioned financial behaviours are jointly-determined. Firms deviate from the desired level of each financial characteristic to absorb shocks to the other financial characteristics. The deviation is followed by a reversion in subsequent periods. Leverage is the most easily-influenced variable among the five, but there is still a clear tendency to revert. Chapter 4 discusses the mechanical effects of other financial behaviours on leverage target adjustments. This chapter extends the traditional partial adjustment model of capital structure by using interaction terms to capture the mechanical effects of other financial behaviours. The results show that capturing other financial behaviours reduces the estimated leverage adjustment speed by around 50%. Beyond that, there is still a substantial fraction of the observed adjustment, which is not controlled by the mechanical effects. This indicates that firms actively adjust their leverage ratio. Chapter 5 evaluates the supply-side effects on firm capital structure. Using a list of macroeconomic proxies, this chapter empirically demonstrates that firm leverage policy is associated with supply-side factors. However, controlling these factors does not eliminate leverage target adjustments. This indicates that the observed leverage target adjustment is not driven by the cyclical supply-side factors. Although firms adjust their leverage ratio to accommodate other financial behaviours and supply-side effects, the results show that leverage target adjustment remains robust. Overall, the evidence in this thesis supports the trade-off theory of capital structure, against the criticism that firm leverage policy might be residually determined. This thesis contributes to understanding corporate financial decisions in dynamic settings.