A Comparative Analysis of Proxies for an Optimal Leverage Ratio

Abstract

Objective: Optimal leverage is one of the anchors of capital structure studies. These studies have used a wide range of debt ratios as the optimal ratio; however, the choice of the proxy can influence the results of the studies. Method: This paper aims to scrutinize the best optimal leverage between the firm’s mean leverage, moving average leverage, industry mean leverage and predicted leverage ratio based on regressions. Choice of the best proxy is based on the speed of adjustment, financing decisions and firm’s market value. Results: The results show that the change in market value is similar for all proxies when leverage deviates away from its optimum. It means as the firm's leverage ratio deviates away from its optimum, its market value declines in the firms whose leverage ratio is above the proxy. But the study of the speed of adjustment and financial decision shows that these alternative proxies yield results that are significantly different from each other. In other words, the conclusions drawn from the findings are sensitive to the model's proxy. Of the proxies in this study, the moving average debt measure exhibits characteristics that are most consistent with the theoretical optimal leverage ratio.

Keywords

• optimal leverage
• trade-off lheory
• speed of adjustment
• financing decisions
• firm's market value