How Much Is Too Much? Debt Capacity and Financial Flexibility
University of Cologne - Department of Corporate Finance; University of Cologne - Centre for Financial Research (CFR)
University of Cologne - Department of Corporate Finance
We estimate the debt capacity of a firm as the critical debt ratio that causes a downgrade in creditworthiness. Unused debt capacities depict the temporal access to external debt funds and measure a firm's financial flexibility. Firms with high unused debt capacities realize a larger fraction of their investment opportunity set, borrow more often, and issue higher volumes of debt. Firms that have exhausted their debt capacity issue equity or pay down debt when having a financial surplus. These patterns of actively using and restoring unused debt capacities imply that preserving financial flexibility is of first-order importance in corporate finance.
Number of Pages in PDF File: 56
Keywords: capital structure, debt capacity, credit ratings, capital budgeting
JEL Classification: G31, G32
Date posted: January 23, 2012 ; Last revised: March 17, 2014
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