A Case for Financial Flexibility in Debt Models

Debt often gets a bad name, but it actually serves a useful purpose on corporate balance sheets. Without it, companies might miss out on valuable investment opportunities and end up with higher tax burdens. On the flip side, runaway debt puts companies in the danger zone for credit default and bankruptcy.

Financial economists have for decades searched for the optimal mix of debt and equity, referred to as capital structure theory. New research by David J. Denis of the Katz Graduate School of Business provides hard evidence toward a missing link in that theory. He and colleague Stephen B. McKeon of the University of Oregon have documented a pattern of behavior in which firms borrowed substantially to deliberately increase debt levels beyond long-run targets, then showed little urgency in winding debt back down to target levels.

The results imply that the first-order concern for managers isn't meeting pre-set debt targets. On the contrary, what appears to matter more is financial flexibility. Having access to capital when they need it is managers' foremost concern, and so long as debt levels don't preclude access, managers tend to pursue a debt-equity mix that often deviates substantially from long-run targets.

"There is a strong incentive for companies to manage their capital structure efficiently," says Denis, Katz's Roger S. Ahlbrandt Sr. Chair and professor of business administration. "In our study, we observed companies who had pushed their leverage substantially away from the target. If the target were that important, you'd expect that they'd act quickly to bring it back closer to the target. Instead, companies often tended to do exactly the opposite."

Denis and McKeon published their findings in the research paper, "Debt Financing and Financial Flexibility Evidence from Proactive Leverage Increases," in the June edition ofReview of Financial Studies.

Highly Leveraged and Not That Concerned

Leverage is the amount of debt that a firm uses to finance its assets. A home mortgage is an example of leverage. By borrowing for a home, a person takes on debt, but gains an asset that will produce some benefits for the homeowner that might otherwise have been impossible.

Denis and McKeon analyzed leverage ratios, which are based on a mathematical formula of a firm's debt relative to its equity. A firm with more debt than equity is considered highly leveraged. Their research sample comprised 2,314 instances between 1971 and 1999 of U.S. firms across industries that proactively increased total debt at least 10 percent above their target ratio. On average, firms were 27 percent above the target, and after seven years, most remained above their targets. For purposes of the study, only firms with assets of more than $10 million were included, and firms in highly regulated industries, such as financial services, utilities, and real estate, were excluded.

"Firms tend to use debt issuances as a primary lever when the need for funds arises. We saw that firms subsequently rebalance to the target, but that process is very slow. Often times they issue more debt that moves them further away from the target. One of the main implications of this is that the traditional models of capital structure theory seem to be missing some important factors," Denis says.

The research observed that two-thirds of leverage increases were for a long-term investment, such as acquisitions or capital expenditures. Firms with a surplus would use it primarily for debt reduction rather than for increases in equity payouts of the firm's cash balance, while firms with a deficit would take on more debt to cover their needs.

"While there is some evidence that firms manage their leverage ratios toward a target, the evolution of a firm's leverage ratio appears to be driven primarily by financial surpluses and deficits rather than a determined pursuit of a stationary target," the researchers wrote.

Financial Flexibility an Undervalued Force

Denis says the findings don't mean that managers are behaving irresponsibly with debt. Instead, they mirror the attitude given by chief financial officers (CFOs) in past surveys. The CFOs stated that financial flexibility is one of the most important determinants of capital structure.

"In our research, they act as if the target isn't important, but what's really going on is that the target itself is missing important information. Managers are more concerned about access to capital over anything else," Denis says.

The research, based on five years of work, provides evidence that firms don't behave in a way that is consistent with standard capital structure theories. Denis and McKeon say it's plausible that a leverage ratio consist of permanent and transitory components. The permanent component represents the company's long-run target, while the transitory component reflects the evolution of the firm's cash flow and operating needs.

"This behavior gives rise to leverage patterns that give the appearance that managers are paying little attention to the costs and benefits of debt," the researchers wrote.

The findings complement recent research indicating that transitory debt sources play a prominent role in a firm's capital structure. In this respect, credit and commercial paper programs carry great importance.

"Empirical estimates fail to incorporate the option value of having debt capacity available for future use," the researchers wrote. "Managers appear to perceive the benefits of optimizing with respect to traditional determinants of leverage (i.e. tax, distress costs) as being relatively low, and the costs of potential underinvestment as being relatively high."