Capital Structure and Equity Liquidity: A Bi-Directional Relationship

Abstract

In this paper, we explore the notion that liquidity and leverage are jointly determined. We first find that as leverage increases, equity bid-ask spreads decrease (i.e., liquidity increases). This result is consistent with the idea that increases in debt are accompanied by an increase in equity volatility which both induces competition among informed traders and attracts uninformed speculators, thereby narrowing spreads. Results from the second stage of a two-stage least squares regression further imply that as liquidity decreases, leverage increases, which accords with the notion that managers rely on debt financing when the cost of equity financing increases. While controlling for the endogenous relationship between spreads and leverage greatly reduces the impact of spreads on leverage, results from our analysis suggest that a one standard deviation increase in spreads results in a 3% increase in leverage. Not only do our results add to the understanding of the complex relationship between capital structure and liquidity, they also shed light on the determinants of leverage and bid-ask spreads.