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Debt Financing and Financial Flexibility: Evidence from Pro-active Leverage Increases

Review of Financial Studies, Forthcoming

AFA 2010 Atlanta Meetings Paper

52 Pages Posted: 17 Mar 2009 Last revised: 20 Jan 2012

David J. Denis

University of Pittsburgh

Stephen B. McKeon

University of Oregon - Department of Finance

Date Written: December 30, 2011

Abstract

Firms that intentionally increase leverage through substantial debt issuances do so primarily as a response to operating needs rather than a desire to make a large equity payout. Subsequent debt reductions are neither rapid, nor the result of pro-active attempts to rebalance the firm’s capital structure towards a long-run target. Instead, the evolution of the firm’s leverage ratio depends primarily on whether or not the firm produces a financial surplus. In fact, firms that generate subsequent deficits tend to cover these deficits predominantly with more debt even though they exhibit leverage ratios that are well above estimated target levels. Our findings are broadly consistent with a capital structure theory in which financial flexibility, in the form of unused debt capacity, plays an important role in capital structure choices.

Keywords: Financial Flexibility, Capital Structure, Rebalancing, Tradeoff, Pecking order

JEL Classification: G32, G35

Suggested Citation

Denis, David J. and McKeon, Stephen B., Debt Financing and Financial Flexibility: Evidence from Pro-active Leverage Increases (December 30, 2011). Review of Financial Studies, Forthcoming; AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1361171 or http://dx.doi.org/10.2139/ssrn.1361171

David J. Denis

University of Pittsburgh ( email )

Katz Graduate School of Business
Pittsburgh, PA 15260
United States
412-648-1708 (Phone)

Stephen B. McKeon (Contact Author)

University of Oregon - Department of Finance ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

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