On Capital Structure and the Liquidity of a Firm's Stock

38 Pages Posted: 6 Feb 2006

See all articles by Laura Frieder

Laura Frieder

Purdue University - Krannert School of Management

Rodolfo Martell

Barclays Global Investors; Purdue University - Krannert School of Management

Date Written: March 7, 2006

Abstract

Though prior capital structure literature suggests a causal relation between liquidity and leverage (i.e., liquidity affects leverage), we explore the notion that these variables are jointly determined. Consistent with the idea that debt forces managers to make better investment decisions, we find that as leverage increases, spreads decrease. Results from our empirical analysis further imply that as liquidity decreases, leverage increases, which is consistent with the notion that managers rely on debt financing when equity financing becomes relatively expensive. While controlling for the endogenous relationship between spreads and leverage greatly reduces the impact of spreads on leverage, results from our method suggest that a one standard deviation increase in spreads results in a 3% increase in leverage. Not only do our results add to the understanding of the complex relationship between capital structure and liquidity, they also shed light on the determinants of leverage and bid-ask spreads.

Keywords: Liquidity, leverage, capital structure, spreads

JEL Classification: G14, G30

Suggested Citation

Frieder, Laura and Martell, Rodolfo, On Capital Structure and the Liquidity of a Firm's Stock (March 7, 2006). Available at SSRN: https://ssrn.com/abstract=880421 or http://dx.doi.org/10.2139/ssrn.880421

Laura Frieder (Contact Author)

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Rodolfo Martell

Barclays Global Investors ( email )

45 Fremont Street
San Francisco, CA 94105
United States

Purdue University - Krannert School of Management ( email )

403 West State Street
KRAN 477
West Lafayette, IN 47907-2056
United States

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