Deviation from target capital structure and cost of equity

This study analyzes the impact of leverage deviation from target capital structure on the cost of equity capital, the sensitivity of the cost of equity to leverage deviation and the speed of adjustment towards target capital structure. The sample covers the period from 2001 to 2017, which consists of 294 firms in Tehran Securities Exchange. The Generalized method of moments (GMM) has been employed to estimate models. Confirming theoretical predictions, the results show that increasing in leverage deviation causes raising equity risk. Shareholders react to this risk by increasing expected returns. Therefore the cost of equity is positively related to leverage deviation. Also that firms whose cost of equity is more sensitive to leverage deviation, have less deviation and exhibit faster speed of adjustment towards target. Accordingly, it seems one of the reasons for the differences in the speed of adjustment in previous studies is the lack of attention to the sensitivity of the cost of equity to leverage deviation. While research findings are sensitive to the financial leverage measurement methods, the financial market-based leverage proxies confirm the results of the research.