The Impact of Financial Flexibility on Capital Structure Decisions: Some Empirical Evidence

Abstract

I empirically test the impact of financial flexibility on capital structure decisions on a large sample of publically traded U.S. firms from 1971 to 2006. I find that accounting for the marginal value of financial flexibility in capital structure models sheds light on several important capital structure questions. First, I show that when the marginal value of financial flexibility is high, variables traditionally shown to impact leverage (e.g., profitability, depreciation and amortization expense, fixed assets, etc.) become less important and explain less of the observed variation in leverage. This is consistent with the notion that financial flexibility is of first-order importance when firms make capital structure decisions. Second, consistent with the predictions of DeAngelo, DeAngelo, and Whited (2010), the results show that firms that have a high marginal value of financial flexibility tend to preserve debt capacity in the current period but are significantly more likely to embark on intentional, but temporary, deviations from their target leverage ratios in the near future. Further, firms which have a high marginal value of financial flexibility that do raise large amounts of financing in the current period are significantly more likely to issue equity than transitory debt in order to preserve debt capacity. This result helps to explain why young, high-growth firms tend to have lower debt ratios than the pecking order or traditional tradeoff models predict. Finally, I show that once the marginal value of financial flexibility is included in a dynamic partial adjustment model, it explains the asymmetric adjustment speeds reported by Byoun (2009). That is, I show that it is only the firms with the highest marginal value of financial flexibility that tend to be reluctant to lever up when they have below their target leverage. Overall, my results highlight the need to account for the marginal value of financial flexibility in empirical tests of capital structure theory.

Keywords: Financial flexibility, capital structure, dynamic capital structure, cash holdings

JEL Classification: G30, G32