Proactive Leverage Increases and the Value of Financial Flexibility
Traditional tradeoff models of corporate capital structure, although still featured prominently in finance textbooks and widely accepted by practitioners, have been criticized by financial economists for doing a poor job of explaining observed debt ratios. Moreover, the observed ratios are far less stable than what would be predicted by the standard tradeoff models. In a study published several years ago in the Review of Financial Studies, the authors of this article aimed to shed more light on the underlying forces governing capital structure decisions by analyzing a set of major changes in capital structure in which companies initiated large increases in leverage through substantial new borrowings. They then attempted to explain why these companies chose to increase leverage and how their capital structures changed during the years after the large debt issues. As summarized in this article, the authors' findings indicate, first of all, that the large debt financings were used primarily to fund major corporate investments and not, for example, to make large distributions to shareholders. And the changes in leverage ratios that came after the debt offerings were driven far more by the evolution of the companies' realized cash flows and their investment opportunities than by deliberate or decisive attempts to rebalance their capital structures toward a stationary target. In fact, many of the companies chose to take on even more debt when faced with cash flow deficits, despite operating with leverage that was already well above any reasonable estimate of their estimated target leverage. At the same time, companies that generated financial surpluses used them to reduce debt, even when their leverage had fallen well below their estimated targets. Taken as a whole, the findings of the authors' study support the idea that unused debt capacity represents an important source of financial flexibility, and that preserving such flexibility and making use of it when valuable investment opportunities materialize may well be the critical missing link in connecting capital structure theory with observed corporate behavior.