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
October 1, 2013
This paper provides explicit evidence that financial flexibility is a first-order concern for corporate financing decisions. Taking a novel approach, we estimate firm-year specific debt capacities based on credit ratings and measure financial flexibility as the firm's unused debt capacity which we call the debt buffer. This measure depicts a firm's temporal access to external debt funds and we find that investments and capital issues are related to past debt buffers. Firms issue debt when their debt buffer is high but avoid exceeding their debt capacity and restore unused debt capacity by issuing equity or paying down debt when their debt buffer is low. Our results indicate that firms target preserving financial flexibility and that the evolution of debt ratios reflects the availability of external debt funds. By studying the financing decisions of firms close to their debt capacity, we rule out the possibility that our results are driven by the trade-off theory of capital structure.
Number of Pages in PDF File: 56
Keywords: capital structure, debt capacity, credit ratings, capital budgeting
JEL Classification: G31, G32working papers series
Date posted: January 23, 2012 ; Last revised: December 3, 2013
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