Temporal Profiles of Cash Flows: Implications for Financial Leverage

Posted: 19 Mar 2012  

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance

Jongsub Lee

University of Florida - Warrington College of Business Administration

Date Written: March 15, 2012

Abstract

This paper investigates empirically the impact on leverage of the two temporal dimensions of cash flows: duration and persistence. We propose a novel estimation of these temporal characteristics, utilizing the return decomposition based on the vector autoregressive (VAR) method and the data on the market values of firms' assets. The key intuition for the estimation is that persistence is the sensitivity of market prices to cash flow shocks and duration is the sensitivity to discount rate shocks. Using these novel measures, we find evidence supporting recent developments in capital structure theory such as Gorbenko and Strebulaev (2010) and Hennessy (2004). First, firms with temporary shocks have low leverage, especially for small and financially constrained firms. Although less important unconditionally, permanent shocks' effect on leverage can be amplified, if they covary negatively with future discount rate shocks. Second, firms with long duration cash flow streams maintain low leverage and invest less in fixed assets, consistent with the notion that long asset life exacerbates debt overhang problems because default truncates future cash flows.

Suggested Citation

Choi, Jaewon and Lee, Jongsub, Temporal Profiles of Cash Flows: Implications for Financial Leverage (March 15, 2012). Available at SSRN: https://ssrn.com/abstract=2024437 or http://dx.doi.org/10.2139/ssrn.2024437

Jaewon Choi (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Jongsub Lee

University of Florida - Warrington College of Business Administration ( email )

Department of Finance Insurance & Real Estate
P.O. Box 117168
Gainesville, FL 32611-7168
United States
352-273-4966 (Phone)
352-392-0301 (Fax)

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