Capital structure and financial flexibility: Expectations of future shocks

Abstract

Abstract We test one of the main predictions of the financial flexibility paradigm, that expectations about future firm-specific investment shocks affect the firm's leverage. We extract the expectations of small and large future shocks from the market prices of equity options. We find that leverage decreases when expectations for any one of the two types of future shocks increase and the relation is statistically significant even when we control for standard determinants of leverage and the firm's probability of default. Expectations for future shocks explain a greater fraction of leverage variation than most standard determinants of leverage do and they affect more the small and financially constrained firms. Our results are not subject to an endogeneity bias and they confirm DeAngelo et al. (2011) model's predictions and the evidence that managers seek for financial flexibility.