Capital structure deviation and speed of adjustment

As a firm deviates from its target leverage from above (below), the bankruptcy costs (foregone tax savings) rise at an increasing rate while the tax savings (reduced bankruptcy costs) rise at a decreasing rate, generating a stronger incentive for rebalancing capital structure. This phenomenon renders the speed of adjustment (SOA) an increasing function of the deviation. Employing a bootstrapping-based estimation strategy that averts well-known estimation biases, we find U.S. firms exhibit a positive SOA sensitivity to leverage deviation. Also, the SOA sensitivity is greater for overlevered than underlevered firms. © 2013 The Eastern Finance Association.