1. Introduction
Do firms have leverage targets? How quickly do they approach these targets? What are the drivers of the targets? What are the impediments to achieving those targets?
We are not the first to ask these questions, and the literature contains little consensus on the correct answers. Recent studies include Leary and Roberts (2005), Flannery and Rangan (2006), Huang and Ritter (2009), and Frank and Goyal (2009). While Welch (2004) is the obvious exception, almost all research in this arena concludes that firms do have targets, but that the speed with which these targets are reached is unexpectedly $ For helpful comments on preceding drafts, we thank Michael Roberts (the referee), Vidhan Goyal, Brad Jordan, Mark Leary, Mike Lemmon, Mitchell Petersen, discussants at the 2008 AFA and FIRS conferences, and seminar participants at Oxford University, Iowa State University, the Federal Reserve Board, UCLA, Ohio State University, and Imperial College. n Corresponding author. Tel.: þ 1 859 257 2774. E-mail address: jason.smith@uky.edu (J.M. Smith). slow. This has moved the literature toward a search for the source(s) of adjustment costs. For example, Fisher, Heinkel, and Zechner (1989) argue that firms will adjust leverage only if the benefits of doing so more than offset the costs of reducing the firm’s deviation from target leverage. Altinkilic- and Hansen (2000) present estimates of security issuance costs, and others have modeled the impact of transaction costs on observed leverage patterns (e.g., Strebulaev, 2007; Shivdasani and Stefanescu, 2010; Korajczyk and Levy, 2003). Leary and Roberts (2005) derive optimal leverage adjustments when transaction costs have fixed or variable components.
However, the cost of adjusting leverage depends not only on explicit transaction costs, but also on the firm’s incentive to access capital markets for other reasons. Profitable investment opportunities will drive some firms to raise external funds, and leverage can be adjusted by choosing between the issuance of debt vs. equity. Other firms (cash cows) routinely generate cash beyond the value of their profitable investment opportunities and may eventually distribute that cash to stakeholders. Leverage can change by choosing to repay debt vs.
repurchasing shares or paying dividends. In short, any sort of capital market access can be used to adjust leverage, if the firm wishes to do so. A firm’s cash flow realization can substantially affect the cost of making a leverage adjustment, regardless of whether the firm is raising or distributing external funds. Firms not otherwise transacting with the market face a higher adjustment cost. Two stylized examples illustrate the joint effect of adjustment costs and cash flows on observed leverage adjustments.
First, consider a firm with a constant target leverage ratio and high costs of accessing external capital markets. It starts out with leverage below its target (optimal) level and would enhance value by closing the gap. In one year, its cash flow realization is near zero and it has few investment opportunities. In the subsequent year, its cash flow falls well below the amount needed to fund all valuable investment opportunities. If accessing external capital markets entails transaction costs, this firm is much more likely to adjust its leverage in the second year. Yet its market access costs have not changed between these two years. Second, consider two firms, both of which are under-levered and wish to move closer to their leverage targets. Firm A faces low costs of accessing external markets, but rarely does so because its operating cash flows are usually sufficient to fund its valuable invest- ment opportunities, but little more. Adjusting Firm A’s leverage would require a ‘‘special’’ trip to the capital markets, and the associated costs would be offset only by the benefits of moving closer to target leverage. Firm B has higher access costs than Firm A, but its operating cash flows are much more volatile. In some years, Firm B’s investment opportunities are so great that funding them requires external capital. In other years, Firm B has large excess cash flows, which it finds optimal to distribute to its stakeholders. While engaging in those capital market transactions, this firm can simultaneously adjust its leverage at relatively low marginal cost. We might there- fore observe that the firm with higher adjustment costs (Firm B) nonetheless adjusts its capital structure more frequently than Firm A.
Both of these examples indicate that a firm’s cash flow situation may substantially affect its net incentive to move toward a target leverage ratio, if it cares about such things. This effect is in addition to the role the various compo- nents of cash flow may have on the target leverage ratio itself. Some previous researchers have investigated the impact of these adjustment cost proxies on target leverage or the choice of securities to issue (e.g., Hovakimian, Opler, and Titman, 2001; Korajczyk and Levy, 2003; Leary and Roberts, 2005). However, we are the first to interact adjustment speed measures with cash flows, and thus evaluate the joint effect of transaction costs and cash flow needs on firms’ adjustments toward target.1
1 In part, this assumption reflects the fact that few researchers estimate capital structure models with endogenous investment Accounting for a firm’s cash flow realization provides significantly different interpretations from what has been documented in the literature. We estimate that firms with cash flow realizations near zero close 23–26% of the gap between actual and target leverage ratios each year. This adjustment speed resembles those reported previously in the literature (e.g., Lemmon, Roberts, and Zender, 2008; Huang and Ritter, 2009). However, firms with cash flows significantly exceeding their leverage deviation exhibit adjustment speeds in excess of 50%. This number rises to greater than 70% if the firm is over-levered. The magni- tudes of these estimated parameters indicate that cash flow realizations have a first-order effect on firms’ con- vergence toward target leverage ratios. By showing that adjustments toward target leverage vary with the mar- ginal cost of implementing leverage changes, we provide empirical evidence consistent with the widely used par- tial adjustment model. Ignoring cash flows therefore imposes an inappropriate constraint on adjustment speeds in typical partial adjustment models of financial leverage. Our results are robust to alternative measures of cash flow, the incorporation of firms’ beginning-of-eriod cash position into the cash flow calculation, and alter- native estimates of the firm target leverage levels.
Our results also bear on the recent evidence that randomly generated leverage adjustments can yield empirical results that resemble leverage-targeting and partial adjustment behavior (e.g., Chang and Dasgupta, 2009; Iliev and Welch, 2010).
Chang and Dasgupta (2009,p. 1794) conclude that for identifying target behavior, ‘‘Looking at leverage ratios is not enough, and even possibly misleading.’’ These studies impose the same adjustment speed on all sample firms.2 One of our con- tributions is to identify ex ante firms that are likely to make larger leverage adjustments based on characteris- tics other than their leverage preferences (if any). The resulting evidence confirms the performance of a partial adjustment model in a more refined environment than studies that estimate the same adjustment speed across all sample firms. Moreover, the large estimated adjust- ment speeds differ greatly in economic significance from the adjustment speeds generated by the Chang and Dasgupta (2009) simulations.
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