Nonlinear Modeling of Target Leverage with Latent Determinant Variables - New Evidence on the Trade-off Theory

The trade-off theory on capital structure is tested by modelling the capital structure target asthe solution to a maximization problem. This solution maps asset volatility and loss givendefault to optimal leverage. By applying nonlinear structural equation modelling, theseunobservable variables are estimated based on observable indicator variables, andsimultaneously, the speed of adjustment towards this leverage target is estimated. Linearspecifications of the leverage target suffer from overlap between the predictions of varioustheories on capital structure about the sign and significance of determinants. In contrast, theframework applied here allows for a direct test: results confirm the trade-off theory for smalland medium-sized firms, but not for large firms.