Precautionary Debt Capacity

Abstract

Firms with ample financial slack are unconstrained... or are they? In a field experiment that randomly expands debt capacity on business credit lines, treated small-and-medium enterprises (SMEs) draw down 55 cents on the dollar of expanded debt capacity in the long-run and increase total debt, investment, sales, and profits by $2.02, $1.83, $7.19, and $3.90 on the dollar, respectively. SMEs with debt levels farthest below their borrowing capacity before the intervention display sizable treatment effects. The likelihood of financial distress in negative cash flow events is reduced for treated firms. Additional analyses support SMEs’ precautionary motive to preserve financial flexibility.