Capital Structure Theory and Retention Policy

Abstract

To explain the low-leverage puzzle, we propose a flexibility-adjusted trade-off model by integrating the motive of keeping financial slack into traditional tax/distress model when capital structure and dividend-retention decision are jointly determined. Our model shows that firms that efficiently utilize retention for reinvestments tend to have lower leverage and pay fewer dividends so as to conserve more cash flow as internal funds, whereas inefficient firms tend to have high dividends and high leverage. Besides, this model also suggests that an appropriate retention policy can help reduce bankruptcy probability and costs. Conforming to financial flexibility hypotheses, the bankruptcy costs of efficient firms negatively relate to retained internal capital; consistent with free cash flow hypothesis, bankruptcy costs of inefficient firms positively relate to retention. Finally, we show that more profitable firms manage to reduce managerial agency costs through issuing debt, whereas firms with higher liquidation costs do that through paying more dividends.