Firm Size and Capital Structure

Abstract:     
Firm size has been empirically found to be strongly positively related to capital structure. A number of intuitive explanations can be put forward to account for this stylized fact, but none have been considered theoretically. This paper starts bridging this gap by investigating whether a dynamic capital structure model can explain the cross-sectional size-leverage relationship. The driving force that we consider is the presence of fixed costs of external financing that lead to infrequent restructuring and create a wedge between small and large firms. We find four firm size effects on leverage. Small firms choose higher leverage at the moment of refinancing to compensate for less frequent rebalancings. But longer waiting times between refinancings lead on average to lower levels of leverage. Within one refinancing cycle the intertemporal relationship between leverage and firm size is negative. Finally, there is a mass of firms opting for no leverage. The analysis of dynamic economy demonstrates that in cross-section the relationship between leverage and size is positive and thus fixed costs of financing contribute to the explanation of the stylized size-leverage relationship. However, the relationship changes the sign when we control for the presence of unlevered firms.

Keywords: Capital structure, leverage, firm size, transaction costs, default, dynamic programming, dynamic economy, refinancing point, zero leverage

JEL Classifications: G12, G32

Working Paper Series