Business Cycle Dynamics and Optimal Leverage
44 Pages Posted: 8 Sep 2010 Last revised: 14 Jan 2014
Date Written: February 20, 2013
This paper explores theoretically and empirically the link between macroeconomic risk and corporate financing policies. In a structural trade-off model of tax benefits and default costs, I introduce EBIT growth and volatility rates that depend on the business cycle. The model shows that leverage and its benefits are larger in expansions than in recessions. A structural break of expansion and recession patterns has a pronounced effect on optimal financing policies. The use of debt increases when recessions become milder and less volatile due to a reduction in expected default costs. In an econometric analysis, I show that my model is able to replicate empirically observed leverage patterns over the business cycle. On a sample of publicly traded US firms, I document pro-cyclical leverage ratios and an increase in leverage ratios after the reduction of macroeconomic risk in the 1980s.
Keywords: Capital structure, Macroeconomic conditions, Leverage, Benefit to leverage
JEL Classification: E44, G12, G32
Suggested Citation: Suggested Citation