A Note on the Dynamics of Target Leverage Ratios

In this communication we have proposed a simple model for the dynamics of the target leverage ratio of a firm and performed a theoretical investigation of its time path. The gap between a firm's current target leverage ratio and the long-term target ratio is found to diminish exponentially, and the decay rate is determined by the volatility of the leverage ratio and the long-term target ratio only. The time-varying target leverage ratios can be readily incorporated into the dynamics of the leverage ratios of individual firms, and the default probabilities of individual firms can be generated to assess the default risks of the firms.