Capital Structure and Financial Flexibility: Expectations of Future Shocks

Abstract

We test one of the main predictions of the financial flexibility paradigm, that expectations about future firm-specific investment shocks affect the firm’s leverage. We extract the expectations of small and large future shocks from the market prices of equity options. We find that leverage decreases in anticipation of an increase in both types of future shocks and the relation is statistically significant even when we control for standard determinants of leverage and the firm’s probability of default. Expectations for future shocks explain more variation of the leverage than standard determinants of leverage do and they affect more the small and financially constrained firms. Our results are not subject to an endogeneity bias and they confirm De Angelo et al. (2011) model’s predictions and the evidence that managers seek for financial flexibility.

Keywords: Capital structure, Financial flexibility, Options, Risk-neutral volatility, Risk-neutral kurtosis

JEL Classification: G13, G30, G32