Cost and Benefit of Debt and Target Adjustment

ijcrb.webs.
com DECEMBER 2011

INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS VOL 3, NO 8
Dynamic or constant movement toward the target capital structure:

Evidence from Jordanian firms
Ziad Zurigat
Assistant professor
Department of Banking and Finance Science
Yarmouk University-Irbid- Jordan
Mona Al-Mwalla
Associate Professor, Department of Banking & Finance
Faculty of Economics & Administrative Sciences
Yarmouk University, Irbid-Jordan
Abstract
This study investigates the short run and the long run impact of target leverage ratio on the
speed of target reversion. Using a sample of 105 nonfinancial firms listed in Amman Stock
Exchange (ASE) over the period of 1997-2009, It uses the points technique to estimate how
far the actual leverage deviates from its target level and how many points a firm corrects each
period. Fixed and random effects results show that Jordanian nonfinancial firms have a target
leverage ratio but move slowly toward their target. The results also reveal that the large part
of deviation is eliminated in the first and second periods and the impetus to eliminate the
divergence from target decline over time with no impetus to correct the target deviation when
firms become closer to their target level. Finally, using points method to estimate the average
time required for firms to correct their target deviation suggests that the required time would
be higher than the time when using the estimated coefficient.
Key words: Adjustment rate, target deviation, timing consideration, financial flexibility,
Amman Stock Exchange.
1. Introduction
Target adjustment theory of capital structure suggests that there is a threshold level of debt,
under which the firm’s value is maximised. The underlying argument of target adjustment or
trade-off theory refers to Modigliani and Miller (1963) who incorporate corporate income tax
and suggests that the value of firm is maximized by using as much debt as possible. This is
because corporate income tax treatment allows for the deduction of interest payments in
computing taxable income, increasing firm’s after-tax income and consequently increasing
its value (Barclay& Smith, 1995, 1999). But the presence of bankruptcy and agency costs of
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ijcrb.webs.com DECEMBER 2011
debt may outweigh its tax benefits,11which trigger the search for target or optimal capital
structure. For value-maximization, the optimal capital structure (target leverage ratio) will be
identified at the point where the marginal benefits of any additional unit of debt used equates
its marginal costs (Tong and Green, 2005), suggesting target adjustment by firms to keep
their actual leverage ratio at its target level. However, in the presence of transaction
(adjustment) costs, target adjustment does not occur immediately, implying partial not
complete target adjustment takes place (Flannery and Rangan, 2006, Myers, 1977). Firms that
follow the targeted path of capital structure tend to trade-off the costs of being away from
their target with that of moving toward that target. The desire to adjust leverage exists when
the cost of being away from the target level is higher than that of moving towards that target
and will continue until the benefits of engaging in adjustment outweigh the costs of that
adjustment. The benefits are typically tax savings, and the costs are typically bankruptcy,
agency and financial distress costs.
Besides the importance of target leverage for value-maximizing firms, the target adjustment
theory which takes into considerations the costs and benefits of debt which become gradually
more significant when target reversion takes place (Brounen et al., 2005). But leverage
expansions may be constrained by the availability of debt at attractive rates and also by
borrowing constraints such as bankruptcy and agency risks, affecting the speed with which
firms can revert to their target leverage. Moreover, the target leverage ratio may vary over
time, making the target adjustment rate difficult to be measured (Titman and Tsyplakov
(2007). To the best of the researchers’ knowledge, the previous studies that have tested the
target adjustment theory in less developed countries(including Jordan) ignored this issue.
Therefore, the main purpose of this study is to investigate the target adjustment theory of
capital structure by considering the possibility that the target leverage ratio may change over
time. Hence, the study will provide an answer to the following questions:
- Is there a short term effects of target leverage ratio.
- What is the size of target deviation in points and how many point the firm is expected to
move towards the target in each period.
11
They assume that debt is risk-free regardless of the amount of debt used, so no firm goes bankrupt. As management acts
on the exclusive behalf of shareholders, no agency costs of debt exits. Further, they assume that all participants in the capital
market have identical information and expectations about the firm’s current and future prospects.

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To answer the above questions, the study develops and tests new empirical models using
pooled and panel data analysis which are usually estimated either by a fixed effects model or
random effects model. Consistent with the underlying objectives of this study, the estimated
fitted values from the conventional leverage ratio will be used as a proxy for the target
leverage ratio. 12 Therefore, it explores the factors involved in determination of target
leverage ratio in Jordan later in section 1.5. Therefore, the current study is structured as
follows: section 1.2 presents the empirical literature of trade-off (target adjustment) theory in
both developed and undeveloped countries (including Jordan). Section 1.3 presents the
determinants of capital structure, theoretical background and defines variables. Section 1.4
present data and empirical models specification with some descriptive statistics and
diagnostic tests for data, while section 1.5 discusses the estimation results of the empirical
models, with a conclusion.
2. Literature review
Since, Modigliani and Miller (1958) introduced their irrelevancy propositions of capital
structure many attempts have been made to set the core stone of finance theory. Several
theoretical and empirical studies that have been done leading mainly to three outcomes: first,
the capital market is imperfect, and hence capital structure is not irrelevant, suggesting that
the presence of capital market frictions such as bankruptcy costs (e.g. Warner 1977), agency
costs (e.g. Jensen and Meckling, 1976; Jensen, 1986), signalling and information asymmetry
(e.g. Ross, 1977; Myers and Majluf, 1984; Myers, 1984) and the existence of non-debt tax
shields (e.g. DeAngelo and Masulis, 1980) may affect firms’ policies in borrowing and
issuing equity. As Jordanian capital market is imperfect, these considerations are relevant and
are expected to be more sever than it would be in developed market. This is because the
Jordanian capital market is thin and small.
Second, the static model of capital structure will not be able to capture the dynamic
adjustment in leverage ratio, implying that the observed leverage ratio is not always the
optimal which suggests that target reversion is required to revert back to the target level of
capital structure. 13 However, the speed with which target reversion occurs differs from one
12
The study excludes the mean of the firm’s leverage ratio and industry mean as proxies for target leverage ratio because
they are assumed to remain constant over the study period; hence, no short run effect exists.
13
Titman and Wessels (1988); Rajan and Zingales (1995); Bevan and Danbolt (2002, 2004); Chen, 2004;
Eriotis, (2007); Booth et al. (2001), amongst others, tested the static model of capital structure. This model
involves the regression of the observed leverage ratio against a number of explanatory variables. Typically, the
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country to another depending on their tax and bankruptcy laws and regulations, making the
costs and benefits of debt become gradually more significant for target adjustment (see,
Brounen et al., 2005). The gradual movement toward the target level by changing debt
reduces the debt-tax-shield and increases the bankruptcy costs, and consequently reducing the
impetus of firms to move toward their target level of capital structure.
Third, Costs and benefits are not the only determinants of the adjustment speed. Besides
costs and benefits of debt, firms may deviate from their target capital structure in response to
the need for financial flexibility (DeAngelo, et al., 2010). Clark et al.,(2009) display that
besides bankruptcy costs and managerial agency costs, the need for financial flexibility, and
development of the domestic equity market have significant effect on adjustment speed.
Drobetz and Wanzenried (2006) add the size of target deviations and economic conditions(
whether they are good or bad) as other determinants to the speed of target adjustment.
Shamshur (2010) argues that constrained and unconstrained firms differ in capital structure
determinants and thereby their adjustment rates. financially unconstrained firms adjust their
capital structures faster to the target level than constrained firms. Moreover, he claim that
macroeconomic factors (GDP and expected inflation) affect the leverage level of
unconstrained firms, suggesting that unconstrained firms correct their capital structure in
response to changes in macroeconomic conditions. De Jong, et al (2008) display that country-
specific factors not only affect leverage level but also influence the significance of firm-
specific factors and their impact on the speed of target adjustment
Byoun, (2008) argues that the impetus of reducing debt is higher than that of increasing debt,
making the rates of downward adjustment faster than that of upward adjustment which
indicates that target adjustment is asymmetric not symmetric. Mahakud and Mukherjee
(2011) display that financial constraints, ownership structure and macroeconomic conditions
affect the speed of target adjustment significantly. Jalilvand and Harris (1984) call attention
to the cost of debt itself and stock price level. Higher interest rates reduce the impetus of
firms to revert to their target. Stock price or timing consideration of stock issuance supports
the argument of both Baker and Wurgler (2002) and Huang and Ritter (2007) regarding the
impact of timing consideration and market conditions on the speed of target adjustment.
Huang and Ritter (2007) postulate that US firms have less incentive to adjust leverage when
the cost of equity is relatively lower than that of debt, suggesting that leverage may deviate in
explanatory variables include; profitability, asset structure, size, tax and non-debt tax shields, growth
opportunities, dividend and earnings volatility.
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response to timing consideration and market conditions. In the same market and roughly over
the same period, Flannery and Rangan (2006) argue that the costs of deviation from target
leverage ratio are significantly important for the US firms, making the benefits of moving
back toward the target too important. According to Flannery and Rangan (2006), US
companies incur low transaction costs when they raise debt funds, making leverage
adjustment toward its target occur at higher rates. Byoun (2008) argues that the speed of
target adjustment depends on whether firms that follow the targeting path face financial
deficit or surplus, or they have positive or negative deviation.
Empirical works reveals that the target adjustment rates differ from one country to another,
from one period to another even in the same country from one industry to another and from
bank-based financial countries to market-based financial countries. For example, Antoniou
et al. (2008) report 59.3 %, 11.1% and 23.6% adjustment rates per year in France, Japan, and
Germany respectively while they report 31.8% and 33.2% rates per year in UK and US
respectively. These countries follow different financial system. while UK and US follow the
market-based financial system, France, Germany, and Japan follows the bank-based financial
system. Compared with what is reported by Antoniou et al. (2008) in UK, Ozkan (2001)
reports 44.3% per year. In USA market, Jalilvand and Harris (1984) report a rate of
adjustment of 55.7% per year while, Leary and Roberts, 2005; Flannery and Rangan (2006)
Huang and Ritter (2007) report 25%, 34.2% and 17% respectively. Compared with what has
been found by Flannery/Rangan (2006) later on, the finding of Fama and French (2002)
suggests that US firms adjust to target capital structures quite slowly, they report adjustment
rate around 10%. Flannery and Rangan attributed the lower rate in Fama and French (2002)
the estimation of target leverage it self.
In resent studies, Lemmon et al. (2008), estimate adjustments of 25% per year for book
leverage in US market. Aybar-Arias et al, (2011)show that SMEs record a speed of
adjustment of roughly 26% which in turn means that they need two years to close half the
leverage gap. In Spanish market, De Miguel and Pindado (2001) report a rate of adjustment
of 79% per year. For Swiss firms, Drobetz and Wanzenried (2006) report a rate o
adjustment of 19.8% per year. Drobetz and Wanzenried (2006) argue that the firm size,
growth rate and the size of deviation from target all impact the speed of adjustment. In
transition economies- Estonia, Slovenia, Latvia, Lithuania- De Haas and Peeters, (2004)
report, on average, adjustment rate of 13.0% per year. Individually, the report different rate

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for each country depends on the country-specific factors14, the size of leverage used15, and the
size and direction of deviation. In general, it ranges from 2% in Slovenia to 19% in Bulgaria,
other countries are in between. In comparative study, Nguyen and Wu (2011) find that US
firm tends to close around 18.7% to 21.8% of the gap between its actual and the target
leverage ratio each year, roughly it needs4.58 to 5.35 years to converge back to its target
leverage ratio. While Japanese firm needs 5.1 to 6.94 years to converge towards the target
leverage. In German, Elsas and Florysiak (2008) report 49% adjustment rate, implying that
firms in German market need roughly two years to eliminate the full divergence of their
actual leverage from its target.
This review of literature suggests that the dynamic trade-off model properly describes firm
behaviour than static models do. However, it shows that empirical studies that have been
conducted in both developed and developing countries on the rate of adjustment are
contradictory which creates a hot dispute among researcher in what affects the speed of
adjustment. Titman and Tsyplakov (2005) call attention to the possibility that target leverage
ratio may vary over time, making the target adjustment rate difficult to measure. To the best
of the researcher’s knowledge, the previous studies that have tested the target adjustment
theory ignored the possibility that target leverage ratio may change over time. Hence, they
ignore the short run effect of target leverage variation on the speed of target reversion.
Moreover, they assume that movement toward target level of capital structure occurs at
constant rate regardless of the distance between the actual (observed) leverage ratio and the
target leverage ratio.
However, there is evidence to suggest that firms that are close to their target are not expected
to close the residual gap because the costs of incremental adjustment are too expensive (De
Haas and Peeters, 2004). This implies that the impetus of moving toward target level of
leverage is expected to gradually decline as the firm's actual leverage ratio become closer to
its target, making the target reversion longer than it would be under the constant rate of
adjustment. Elsas and Florysiak (2008) who reported 49% rate of adjustment in German,
claim that in real world, the speed of adjustment is about 7.1%. This might suggest the need
14
Antoniou et al. (2008) provide evidence supporting this argument. Antoniou et al. (2008) investigate
the target adjustment theory of capital structure in US, UK, France, Japan, and Germany firms.
15
Flannery and Rangan (2006) argue that firms with high leverage adjust their leverage faster than those with
low leverage, implying that deviations from targets are more costly for highly-leveraged firms.

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for setting new method to estimate the real movement toward the target, such as the points
measure, that is what the current study is going to test.
3. Sample, Data and models specification
3.1 Sample and Data
For the present study, a sample of 105 out of 162 non financial firms listed in Amman Stock
Exchange (ASE) is selected. Because of the specific nature of their capital structure (Rajan
and Zingals, 1995), and special tax treatments compared with non-financial firms (Lesfer,
1995), all financial firms are excluded. Moreover, all firms engaged in merger or liquidated
(whose stocks are delisted in ASE ) during the study period are excluded from the sample. As
the study uses a balanced panel data for analysis, all firms with missing data or incorporated
after 1997 are excluded. Hence, the study includes only the non-financial firms that have
been continuously listed on Amman Stock Exchange (ASE) and that had published data
continuously for at least 13 years, more precisely, during the period of 1997-2009. The
application of these criteria have resulted in a final number of 105 companies with 1378
observations for each variable in thirteen years. The use of panel data analysis to estimate all
empirical models generates more informative data, more variability, less collinearity among
variables, more degrees of freedom, and more efficiency (Gujarati, 2003). It also takes a
firm’s heterogeneity explicitly in considerations by allowing for individual-specific variables
and provides robust parameter estimates than pooled data or time series and cross-sectional
data (Gujarati, 2003). Hausman and Breusch and Pagan Lagrange multiplier (LM) tests will
be used to discriminate between fixed random effects estimators and to discriminate between
pooled and panel data estimators.
The data for pooled and panel econometrics techniques is extracted from the firm’s annual
reports, and from Amman Stock Exchange’s publications (The Yearly Shareholding
Companies Guide and Amman Stock Exchange Monthly Statistical Bulletins).
3.2 Empirical models specification
The current study presents a range of empirical models to investigate; first whether the
Jordanian listed firms have target leverage ratio and moved gradually toward their target
ratios when their leverage deviates from their target, Second; the short run and long run
effects of target adjustment on the speed of target reversion and third, the target deviation in

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points and how many points will be corrected each period or how long it needs to remove
these points.
It has been argued by Myers (1984); Shyam-Sunder and Myers (1999) and Flannery and
Rangan (2006) that the presence of adjustment costs (the costs of switching from debt to
equity and vice versa) may hamper the firms’ ability to revert to their target capital structure
immediately, suggesting the occurrence of partial adjustment toward the target level. This
implies that the firms’ observed leverage ratio not always being equal to their target level,
making the dynamic trade-off (target adjustment) model correctly describes firm financing
behaviour. The dynamic model of capital structure has developed used by Shyam-Sunder and
Myers (1999); Flannery and Rangan (2006) and Byoun (2008), amongst others.
The partial adjustment model as in Shyam-Sunder and Myers (1999) can be formalized as
follows:
(
ALit − ALit −1 = ϕ TL∗it − ALit −1 ) (1)
Where, (TL*it ) is the target leverage ratio, ( ALit ) is the actual leverage ratio. ( ALit − ALit −1 ) is
the net change in leverage, (TL*it − ALit −1 ) measure how far the actual leverage ratio deviates
from the target leverage ratio. ϕ1 is the adjustment coefficient that measures the speed of
target adjustment. In order for partial adjustment to exist, ϕ1 should be between zero and one
( 0 < ϕ1 < 1 ), not zero or one. At ϕ1 = 1 a complete adjustment toward the target occurs,
implying that (TL*it = ALit −1 ) , while at ϕ1 = 0 , no adjustment toward the target takes place
because the adjustment costs are high enough to eliminate the benefit of moving toward the
target. ϕ1 > 1 implies an adjustment more than necessary (Over-adjustment).
As the main objectives of this study are to estimate the size of deviation in points and capture the
short run and long run effects of target leverage ratio, model (1) will be modified by constructing
new variables. The modified model requires the estimation of long relationship and short run
dynamics of the variables under considerations. The long run relationship between ALit
and TL*it can be estimated by regressing ALit on TL*it as follows:
ALit = λ1TL*it + ε it (2)
The coefficient of TL*it (λ1 ) on equation (2) reflects the equilibrium effect of the target
leverage ratio on the actual (existing) leverage ratio, often referred to as the long run effect.
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At equilibrium, λ1 is assumed to be one, the below one coefficient indicates that the target
will not be reached, supporting the view of De Haas and Peeters, (2004) that firms that are
close to their target are not expected to close the residual gap because the costs of incremental
adjustment are too expensive (De Haas and Peeters, 2004), making λ1 to be less than one.
∆TL*it is the change in target itself and its coefficient λ0 reflects the short-run effect of the
target leverage ratio on the actual leverage ratio. Hence, model (1) can be formalized as
follows:
( )
∆ALit = α 0 + α 1 TL*it − λ1 ALit −1 + λ0 ∆TL*it + ε it
(3)
Model (3) can yield both the long-run relations among variables and the short-run
adjustment dynamics towards the long-run target leverage ratio. Adding ∆TL*it variable to
the target adjustment model as an explanatory variable captures the effect of target variation
on the target adjustment rate. This variable exist only if the estimated fitted values are used as
proxy for target or optimal leverage ratio because other proxies for target remain constant
over the study period, making the change in target leverage ratio equals to zero.
It is worth noting that debt expansion will gradually reduces the tax benefit of debt and
increasing the cost of financial distress such as the bankruptcy and agency costs of debt,
which reduce the motion of movement toward target, and consequently slowing target
adjustment gradually. Moreover, if the fixed costs comprise a major segment of the total cost
of adjusting capital structure, firms that deviate from target will change their capital structure
only if they are sufficiently far away from the target capital structure, making the probability
of adjusting leverage positively related to the size of deviation from the target (Lo and Hui,
2009).
Previous empirical studies have assumed that movements toward target occur at constant rate
regardless of the size of deviation. However, there is evidence to suggest that the impetus of
moving toward target level of leverage is gradually declined as the firm's actual leverage
ratio become closer to its target, making the target reversion longer than it would be under
16
the constant rate of adjustment (De Haas and Peeters, 2004). To compare the time
16
The study uses the following formula to calculate the time required to eliminate half of the
deviation of the actual leverage ratio from the target one: ln (1/2) / ln (1-TRAC coefficient).
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required adjusting leverage under the constant rate of adjustment with that of dynamic rate,
we need to calculate how many points the actual leverage deviates from target using the
following formula:
λ1
PT = (3.a)
α1
Where, PT is the deviation from target in points.
The short run effect of target on actual leverage can be measure in point (if λ0 is statistically
significant, otherwise, no short run effect exists) as
SR po int = λ0 * PT (3.b)
The portion of the movement toward target in the next period (M t+1) can be calculated as:
M t +1 = α 1 * (PT − SR po int ) (3.c)
Where, PT − SR po int is the net number of points after subtracting the short run effect, if it
exists.
In the following period (M t+2),
M t + 2 = α 1 * (PT − M t +1 ) (3.d)
Where, (PT − M t + 2 ) is the net number of points after subtracting the points that the firm has
moved in the first period and the same for the third period t+3, (PT − M t + 2 ) until the
deviation points approach to zero and the target is reached.
4. Empirical results
4.1 Dynamic adjustment model
The diagnostic tests suggest that the fixed effects model is the best specification for the study
sample. This finding is highly confirmed by the statistically significant of both Lagrange
Multiplier (LM) and significant Hausman tests (these results are also found for target
adjustment model). Breuch-Pagan test for heteroskedasticity does not provide evidence
against the null hypothesis that the variance of the residuals is homogenous. The Shapiro-

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Wilk W. test for normality provides evidence against the null hypothesis that the residual is
normally distributed, implying that some transformation of the variables may be necessary
(log transformation). Furthermore, no multicollinearity problem exist as signified by the low
value of Variance Inflation Factor (VIF). On overage, it is amounted to 1.37. For all
explanatory variables, the VIF is ranged between (1.11 – 1.67).17
For the purpose of this analysis, the estimated fitted values from the conventional leverage
equation will be used as proxy for the target leverage ratio. The other proxies for target
leverage ratio create zero change which will not fit the purpose of estimating the short run
effect of the target leverage reversion. Following Bevan and Danbolt (2002and 2004), Rajan
and Zingles (1995), we use tangible assets, growth opportunities (market to book ratio), firm
size and profitability as suggested determinants of capital structure. We hypothesize that
profitability, size and tangibility are positively related to leverage, while growth opportunities
are negatively related to leverage. As signified by the Lagrange Multiplier (LM) and
significant Hausman tests the fixed effects model is the best specification. The estimation
results of the conventional leverage equation are presented in table (1).18
As seen in table 3, all variables are statistical significant at 1% and 5% expect taxes are
found to be statistically insignificant. The finding of tax and tangibility is not surprised
because the Jordanian tax system does not encourage firms to generate more debt for tax
consideration. This is because it allows only loss carry forward not backward which reduces
the tax advantage of debt financing. Profitability is negatively related to leverage which
supports the prediction of pecking order theory.
The estimation results of equation 2 report that the coefficient on the TL*it variable is
statistically significant at 5% level, suggesting that Jordanian firms have a long run target
leverage ratio. However, the significant non-one value of λ1 implies the target leverage will
never be reached.19 Hence, firms with actual leverage close to its target level will have no
17
As a rule of thumb, a VIF greater than 10 indicates the presence of harmful collinearity (Gujarati, 2003).
18
The conventional leverage equation that will be used to estimate fitted values as a proxy for the target ratio,
LEVit = δ 0 + δ 1 PROFit −1 + δ 2TANG it _ 1 + δ 3 SZ it −1 + δ 4 GRTH it −1δ 5TAX + ε it where, PROF is the
earning before interest and taxes over total assets, TANG is the net fixed assets over total asset, SZ (size) is the natural
logarithm of total assets, GRTH is the growth opportunities measured by the Market-to-book ratio. TAX is the tax
rate.
19 TL*
it variable is 0.921 and the result of the Wald test suggests tthat its
The estimated coefficient on the
values statistically different from one.
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impetus to correct the remaining gap because of the higher cost of making incremental
adjustment. For the remaining gap, the costs of moving toward target( transaction costs,
bankruptcy and agency costs) are much higher than those of staying away from the target( the
tax benefits lost). The low costs of being away from the target leverage ratio may be
attributed to the Jordanian tax system which does not provide Jordanian firms with more tax
advantage on debt. It is not important when firms experience losses.
Table(1): The estimation results of the conventional leverage equation

The dependent variable is the leverage ratio
measured as total assets to the total liabilities
Estimation technique Pooled OLS Fixed effects Random effects
Variables Coefficient Coefficient Coefficient
Intercept -4.325* -4.602* -4.799*

(0.000) (0.000) (0.000)
PROF -0.138* -0.144* -0.152*
(0.005) (0.000) (0.000)
TANG 0.177** -0.227 -0.017
(0.097) (0.193) (0.817)
SZ 0.227* 0.223* 0.247*
(0.000) (0.001) (0.000)
GRO 0.027*** 0.015 0.025*
(0.058) (0.018) (0.062)
TAX 0.085 0.105 0.089
(0.214)_ (0.362) (0.219)
R2 0.50 0.53 0.47
P-value (0.000) (0.000) (0.000)
LM test 177.95
(0.000)
Hausman test 9.21
(0.000)
The results also show that λ0 is statistically significant at 5% level with estimated value of
0.082 which supports the view that the target leverage may change over time. More precisely,
the low-value coefficient on ∆TL*it variable suggests the presence of short run effect of target
leverage on the speed of target adjustment, but, it was too low. It is worth noting that firms

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change their target level to absorb the effect of market factors ( out of control) on their
values. The geographical location of Jordan besides other factors such as the lack of financial
resources, trade deficit and public debt makes the Jordanian capital market largely affected by
any economic and political instability in the world.
As the long run effect can be deducted by the value of α 1 , the results shows that the
estimated value was 0.31 and statistically significant at 1% level, implying that Jordanian
firms follow the path of targeting leverage, but make their target adjustment relatively slow.
The relatively low coefficient( α 1 ) suggests that Jordanian firms have relatively large
transaction costs. This might be possible for Jordanian firms because these firms rely less
heavily on banks to raise long term debt and also have no developed and large bond market
to raise debts. Because of uncertainties that over shadowed the area due to the Gulf crises
and Iraq occupation, Jordanian banks adopt more conservative credit policies which reduce
Jordanian firms' ability to raise funds. These banks offer debt only to less risky firms- to
larger and more profitable firms. By considering the constant rate of movement toward target,
Jordanian firms needs 3.74 years to revert to the target level. However, the non-one value of
λ1 indicates that although Jordanian firms adjust their leverage towards its target, the target it
self will never be reached. For those with leverage deviation from the target, the large part of
deviation will be closed in the first two periods of target adjustment.
The results reveals that, on average, the actual leverage of Jordanian firms deviates from
target by roughly 3 point( 0.92/0.31=2.97), 0.24 point of deviation is closed in the year of
setting the target leverage ratio ( short run effect), 67% of the deviation is closed in the next
three periods of setting the target( 0.86 point in the first period, 0.60 point in the second one,
and 0.41 point in the third period), while the firm takes more than 10 years to cover the
remaining gap. This suggests that the impetus of moving toward the target may approach to
zero before the gap between the actual and target leverage ratio is closed.

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Table 2: The estimation results of model 3

Dependent variable: the change in total debt/total asset
Independent Pooled OLS Fixed Random effects
variable model effects model
model
Intercept 1.625* 2.021* 1.520*

(0.003) (0.000) (0.002)
(TL*it − λ1 ALit −1 ) 0. 331** 0.312* 0. 328*

(0.070) (0.002) (0.015)
∆TL*it 0. 101 0.082** 0. 094**

(0.245) (0.043) (0.065)
R2 0.48 0.53 0.49
P-value (0.000) (0.000) (0.000)
N 1365 1365 1365
LM Test 266.93 -
(0.000)
Hausman Test - 1.69 -

(0.008)
4.2 Robustness test
As robust test, we split the value of target deviation (TL*it − λ1 ALit −1 ) into four categories
depending on the size of deviation. This specification allows us to explore whether target
reversion becomes more sensitive to the size of deviation from its targets, i.e. firms may
become less sensitive in adjusting leverage ratio when the deviation from the target level is
small, while they are more sensitive in adjusting leverage when the deviation is too large,
implying that the costs of being away from the target are higher for large deviations than
small deviations.
For the purpose of new model development, we first set (TL*it − λ1 ALit −1 ) = TLDit ,then split the
TLDit into two variables by using the dummy variable ( (Dit ) which is equal one for any value

324
of TLDit exceeds its medium and zero, otherwise. This criteria results in two variables
TLDitsie1 andTLD itsize 2 as follows:
TTDitsize1 = TLDit if TLD it > median , TLD it = 0, otherwise
TTD itsize 2 = TLD it if TLD it < median , TLD it = 0, otherwise
TLDitsie1 andTLD itsize 2 are divided into two variables of each by following the same criteria used
to split TLDit .
For TLDitsie1
TLD itsize1 A = TLD itsize1 if TLD itsize 1 > median , TLD itaize 1 A = 0, otherwise
TLD itsize1B = TLD itsize1 if TLD itsize 1 < median , TLD itaize 1 B = 0, otherwise
For TLD itsie 2
TLD itsize 2 A = TLD itsize 2 if TLD itsize 2 > median , TLD itaize 2 A = 0, otherwise
TLD itsize 2 B = TLD itsize 2 if TLD itsize 2 < median , TLD itaize 2 B = 0, otherwise
The substituting of TLD itzise 1 A , TLD itsize 1 B , TLD itsize 2 A and TLDitsize 2 B for the (TL*it − λ1 ALit −1 )
variable into equation3 results in:
∆ALit = ϕ 0 + ϕ1TLD itsize1 A + ϕ 2TLD itsize1B + ϕ 3TLD itsize 2 A + ϕ 4TLD itsize 2 B + ε it (4)
Model 4 allows for adjustment coefficient to vary depending on whether the deviations from
the target are large or small which help investigating whether the firm continue adjusting its
leverage until the gap is totally closed or not. ϕ i should be greater than zero for target
convergence or at least one or more not equal zero. For testing the individual null hypotheses
ϕ1 = 0, ϕ 2 = 0, ϕ 3 = 0, and ϕ 4 = 0, , and the joint test ϕ1 = ϕ 2 = ϕ 3 = ϕ 4 ,Wald test is used.
The rejection of null hypotheses suggests that firms have target leverage ratio but leverage
target reversion is largely affected by the size of deviation from the target level.
The results presented in Table (3) show that ϕ 1 , ϕ 2 and ϕ 3 are statistically significant at
1% and 5% while, ϕ 4 is not significant, suggesting that firms have no impetus to revert back
to their target when their actual leverage ratios are nearly closed to the target. This is because

325
the costs of being away from the target is much lower than the costs of moving toward the
target.
Table 3: The estimation results of model 4

Dependent variable: the change in total debt/total asset
Independent Pooled OLS Fixed effects Fixed effects
variable model model model
Intercept 1.894 0.894 2.251
(0.045) (0.033) (0.048)
TLD itsize1 A 0.571 0.591 0.579

(0.000) (0.000) (0.000)
TLD itsize1B 0.362 0.332 0.351

(0.000) (0.007) (0.000)
TLDitsize 2 A 0.184 0.144 0.170

(0.020) (0.000) (0.405)
TLDitsize 2 B 0.214 0.194 0.208

(0.098) (0.214) 0.325)
R2 0.44 0.48 0.46

P-value (0.000) (0.000) (0.000)
N 1365 1365 1365
LM Test 78.19 - -
(0.000)
Hausman Test - 11.87 -
(0.005)
Although ϕ 1 , ϕ 2 and ϕ 3 are found statistically significant, the results show that they are
not equal. The estimated coefficients are 0.591 , 0.332 and 0.144 respectively. These results
suggests that the large part of deviation is closed in the first period, and the tendency to
correct that deviation is declined over time. For large deviation TLD itzise 1 A , There actual
leverage will be much lower than the target one. Hence, increasing debt will increase the tax
advantage of debt with the bankruptcy and agency costs debt. But at low level of actual
leverage, it is expected that the marginal benefit of any additional debt used be higher than
its marginal costs, making the costs of being away from the target higher that that of moving
toward the target. This might explain why the estimated coefficient of TLD itzise 1 A , variable is
higher than that of TLD itsize 1 B , TLD itsize 2 A variables. But as debt increases, the bankruptcy and
326
agency costs of debts is increasing at increasing rate, reducing the net tax benefits of debt and
consequently, reducing the impetus of Jordanian firms to move toward their target much
quickly.
Summary and Conclusion
In this paper, we have considered the potential effect of the presence of short run effect of
target capital structure (leverage ratio) variation on the speed of target adjustment by
estimating the partial adjustment model. To achieve the study goals, we modify the partial
adjustment model to include the change in target leverage ratio as additional independent
variable along with target deviation variable. The target deviation variable has been
constructed to measure how far the actual leverage ratio deviates from its target. Furthermore,
the study uses the points method to measure how far the actual leverage ratio deviates from
its target in order to estimate how many point a firm moves each period.
Using a sample of 105 non-financial firms listed in Amman Stock Exchange, the results indicate
that these firms have a target leverage ratio, but they move much slowly toward their target.
The results also reveal that target reversion process has both short run and long run effects
implying that Jordanian nonfinancial firms modified their target leverage ratio frequently.
Moreover, the results show that the large part of target deviation is corrected in the first and
second periods and the impetus to correct that deviation declines over time where no impetus
exists when they become more closer to their target leverage level.

327
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Cost and Benefit of Debt and Target Adjustment

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com DECEMBER 2011

Dynamic or constant movement toward the target capital structure:

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- Is there a short term effects of target leverage ratio.

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3. Sample, Data and models specification

3.1 Sample and Data

3.2 Empirical models specification

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and TL*it can be estimated by regressing ALit on TL*it as follows:

ALit = λ1TL*it + ε it (2)

Where, PT is the deviation from target in points.

M t +1 = α 1 * (PT − SR po int ) (3.c)

In the following period (M t+2),

4.1 Dynamic adjustment model

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Table(1): The estimation results of the conventional leverage equation

Estimation technique Pooled OLS Fixed effects Random effects

Variables Coefficient Coefficient Coefficient

Intercept -4.325* -4.602* -4.799*

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Table 2: The estimation results of model 3

Intercept 1.625* 2.021* 1.520*

(TL*it − λ1 ALit −1 ) 0. 331** 0.312* 0. 328*

∆TL*it 0. 101 0.082** 0. 094**

R2 0.48 0.53 0.49

P-value (0.000) (0.000) (0.000)

N 1365 1365 1365

Hausman Test - 1.69 -

4.2 Robustness test

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TLDitsie1 andTLD itsize 2 as follows:

TTDitsize1 = TLDit if TLD it > median , TLD it = 0, otherwise

TTD itsize 2 = TLD it if TLD it < median , TLD it = 0, otherwise

For TLD itsie 2

variable into equation3 results in:

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Table 3: The estimation results of model 4

TLD itsize1 A 0.571 0.591 0.579

TLD itsize1B 0.362 0.332 0.351

TLDitsize 2 A 0.184 0.144 0.170

TLDitsize 2 B 0.214 0.194 0.208

R2 0.44 0.48 0.46

Summary and Conclusion

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[34] Ross, S. (1977). The Determination of Financial Structure: the Incentive-Signalling

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and TLit can be estimated by regressing ALit on TLit as follows:

∆TL*it 0. 101 0.082 0. 094