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Cash Flows and Leverage Adjustments

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). Almost all research in this arena concludes that firms do have targets (Welch, 2004, being the obvious exception) but that the speed with which these targets are reached is unexpectedly slow.

This has moved the literature towards a search for the source(s) of adjustment costs. For example, Fisher et al. (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. re-purchasing 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.

Cash Flows and Leverage Adjustments