Capital Structure, Payout Policy, and Financial Flexibility

by Harry DeAngelo* Linda DeAngelo*

July 2006 Revised October 10, 2007

Abstract We combine elements of the pecking order and trade-off theories of capital structure to develop a more powerful and empirically descriptive theory in which firms have low long-run leverage targets, debt issuances are temporary deviations from targetto meet unanticipated capital needs, firms rebalance to target with a lag despite zero adjustment costs, and mature firms pay substantial dividends to foster access to external equity while limiting internal funds to control agency costs and reduce corporate taxes. The theory generates new testable hypotheses and resolves the main capital structure puzzles including (i) why equity is not “lastresort” financing, (ii) why profitable firms pay dividends and maintain low leverage despite the corporate tax benefits of debt, (iii) why firms fail to “lever up” after stock price increases, and (iv) why leverage rebalancing occurs with a lag despite trivial adjustment costs.

This work was supported by the Charles E. Cook/Community Bank and Kenneth King Stonier Chairs at the Marshall School ofBusiness of the University of Southern California. We thank Eugene Fama, David Hirshleifer, Ronald Masulis, Jay Ritter, Berk Sensoy, René Stulz, Amir Sufi, and Mark Westerfield for helpful comments on an earlier draft. [email protected] or [email protected]

Capital Structure, Payout Policy, and Financial Flexibility 1. Introduction Financial flexibility is the single mostimportant determinant of capital structure according to CFOs (see, e.g., Graham and Harvey (2001)), yet the only prominent theory to recognize its value –Myers and Majluf’s (1984) pecking order model — has serious empirical shortcomings. In fact, Fama and French (2005) conclude that the pecking order is “dead” as a stand-alone theory of capital structure because of its inability to explain whyequity issues are commonplace, and are not exclusively the financing vehicle of last resort. Extant trade-off theories of capital structure fare no better empirically, since they fail to explain (i) why firms do not “lever up” after large stock price increases, (ii) why many profitable firms maintain low debt, thus forego interest tax shields available at little distress risk, and (iii) why leveragerebalancing is difficult to detect and, when detected, why it occurs with a delay that is not plausibly explained by adjustment costs. The empirical corporate finance literature which, as Fama and French (2005, pp. 580-581) note, in recent years has largely focused on running a “horse race” between the pecking order and trade-off theories, is now left with no empirically viable theory of capitalstructure. This paper argues that financial flexibility is the critical missing link for an empirically viable theory, but that the pecking order fails to deliver that theory because its numerous restrictive assumptions narrow its focus sufficiently to preclude a meaningful analysis of the impact of financial flexibility on corporate financial policies. Specifically, the pecking order theory fallsshort because it (i) focuses on a “one-shot” financing decision, thus it rules out the inter-temporal trade-offs that are central to firms’ debt capacity utilization decisions, (ii) assumes that asymmetric information allows self-interested managerial behavior at security issuance, but at no other time, thus it ignores the fact that asymmetric information also engenders agency costs, i.e., it allowsmanagers to benefit themselves at outside stockholders’ expense by over-retaining corporate resources, (iii) assumes away any effect of corporate taxes on optimal cash balances and debt levels, which is likely to be non-trivial, and (iv) ignores the inherent interdependence of capital structure and equity payout policies, a factor which we show has important implications for how firms build,…