What is the Relationship between Financial Leverage and the Expected Cash Flow?

Abstract

Despite the theoretical attractiveness of the tradeoff theories of corporate capital structure, many of their main predictions still lack empirical support. For example, the existing empirical studies have consistently found a negative relationship between financial leverage ratios and cash flow (or profitability) ratios. This negative relationship is viewed as strong evidence against the tradeoff theories (Myers 1990). Rather than using the "stock" approach of the previous studies, this paper uses a "flow" approach designed to capture more precisely the implication of the tradeoff theories. We find that, for most firms, the amount of debt due in a period and the level of cash flow expected in that period are positively related. This evidence is consistent with several major tradeoff theories. It also provides support for the conventional wisdom that debt payments and cash flows should be matched.

JEL Classification: G32