Capital Structure and Equity Liquidity

52 Pages Posted: 19 Mar 2008 Last revised: 3 Feb 2009

See all articles by David A. Lesmond

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Philip F. O'Connor

University of Auckland - Department of Accounting and Finance; University of Waikato - Management School

Lemma W. Senbet

University of Maryland - Robert H. Smith School of Business

Date Written: March 26, 2008

Abstract

This paper investigates the relationship between capital structure and stock liquidity surrounding pure leverage recapitalizations. A substitution of debt for equity in the firm's capital structure concentrates private information in the remaining equity, increasing the informational asymmetry of the firm's equity, leading to increases in the firm's equity liquidity costs. Changes in the firm's leverage are associated with both changes in the probability of informed trading in the firm's stock and with changes in the firm's underlying equity liquidity even after controlling for changes in the commonly used liquidity, equity volatility, or capital structure choice control variables. In aggregate, leverage increasing firms experience an increase of 1% in the bid-ask spread and leverage decreasing firms experience a decrease of 2% in the bid-ask spread. We argue that leverage's effect on equity liquidity costs represents an economically relevant cost to debt usage, and this cost potentially reduces firm value relative to a zero transaction costs environment.

Keywords: Liquidity Costs, Capital Structure

JEL Classification: C34, G14, G20

Suggested Citation

Lesmond, David A. and O'Connor, Philip F. and Senbet, Lemma W., Capital Structure and Equity Liquidity (March 26, 2008). Robert H. Smith School Research Paper No. RHS 06-067. Available at SSRN: https://ssrn.com/abstract=1107660 or http://dx.doi.org/10.2139/ssrn.1107660

David A. Lesmond (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
511 Goldring-Woldenberg Hall
New Orleans, LA 70118
United States
504-865-5665 (Phone)
504-865-6751 (Fax)

Philip F. O'Connor

University of Auckland - Department of Accounting and Finance ( email )

Private Bag 92019
Auckland 1001
New Zealand
+649-923-9431 (Phone)

University of Waikato - Management School ( email )

Hamilton
New Zealand
+64 7 838 4466 (Phone)

Lemma W. Senbet

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2242 (Phone)
301-405-0359 (Fax)

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