Can Financial Flexibility Explain the Debt Conservatism Puzzle? Cross-Country Evidence from Listed Firms

Abstract

The question why firms voluntarily forgo considerable portions of their debt capacity is puzzling financial economists. Across a wide range of industries and countries, empirically observed equity ratios are significantly higher as expected by classical capital structure theories. A potential explanation is provided by the financial flexibility theory, which was recently put forward in the theoretical literature. Under this view, firm choose long-run optimal target debt levels that balance tax advantages from debt against not only distress costs, but also against the opportunity cost of restricting their future financial flexibility. While theoretically financial flexibility theory may explain debt conservatism, empirical support for this view is still very limited. In this paper we test the financial flexibility theory on a large sample of publicly traded European firms from 1998 to 2008. Based on a novel measure of financial flexibility our empirical analysis provides robust evidence that firms maintain lower leverage ratios if financial flexibility is particularly valuable for them. The impact of financial flexibility on leverage is of both high statistical and economic significance. Overall, our findings demonstrate that the desire to preserve financial flexibility is an important although hitherto largely ignored capital structure determinant.