Asset Volatility and Capital Structure: Evidence from Corporate Mergers

Abstract

We exploit cross-sectional variation in the predictable changes in asset volatility following corporate acquisitions to identify the effect of business risk on capital structure. We find that post-merger changes in leverage and cash holdings are strongly predicted by expected asset volatility changes estimated using pre-merger information. These capital structure adjustments are partly achieved through the choice of payment method. Our findings provide direct evidence for the coinsurance effect of mergers on debt capacity. More broadly, they suggest that firm risk is a first-order determinant of leverage, consistent with the trade-off theory of capital structure. Our coefficient estimates imply that a one standard deviation decline in a firm's asset volatility corresponds to a 7.5 percentage point increase in leverage.

Keywords: Capital structure, Mergers and acquisitions (M&As), Corporate cash holdings, Financial synergy

JEL Classification: G30, G32, G34