Dynamic Capital Structure Adjustment and the Impact of Fractional Dependent Variables

Researchers in empirical corporate finance often use bounded ratios (e.g., debt ratios) as dependent variables in their regressions. Using the example of estimating the speed of adjustment toward target leverage, we show by Monte Carlo and resampling experiments that commonly applied estimators yield severely biased estimates, as they ignore that debt ratios are fractional (i.e., bounded between 0 and 1). We propose a new unbiased estimator for adjustment speed in the presence of fractional dependent variables that also controls for unobserved heterogeneity and unbalanced panel data. This new estimator is suitable for corporate finance applications beyond capital structure research.