Abstract
This paper investigates the relationship between capital structure and stock liquidity surrounding pure leverage recapitalizations. A substitution of debt for equity in the firm's capital structure concentrates private information in the remaining equity, increasing the informational asymmetry of the firm's equity, leading to increases in the firm's equity liquidity costs. Changes in the firm's leverage are associated with both changes in the probability of informed trading in the firm's stock and with changes in the firm's underlying equity liquidity even after controlling for changes in the commonly used liquidity, equity volatility, or capital structure choice control variables. In aggregate, leverage increasing firms experience an increase of 1% in the bid-ask spread and leverage decreasing firms experience a decrease of 2% in the bid-ask spread. We argue that leverage's effect on equity liquidity costs represents an economically relevant cost to debt usage, and this cost potentially reduces firm value relative to a zero transaction costs environment.
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