Financial Life Cycle and Capital Structure

Abstract

In this study, we present evidence of a distinctive inverted-U-shaped relation between leverage and retained earnings (RE)—our proxy for financial life cycle stage. Our results suggest that (i) low-RE firms have low leverage because of their heavy reliance on external equity due to financial constraints, (ii) medium-RE firms have high leverage because of their active use of debt in funding high growth, and (iii) high-RE firms have low leverage because of their ability to generate internal funds that exceed funding requirements. The traditional leverage regression that does not account for this inverted-U-shaped relation grossly underestimates the leverage of medium-RE firms but overestimates the leverage of low- and high-RE firms. The data show that retained earnings convey information about both asset growth and profitability. Thus, the inverted-U-shaped relation arises because capital structure decisions are determined by the interplay between funding requirements (i.e., asset growth) and the availability of internal funds (i.e., profitability). We find that the relation between leverage and profitability is also inverted- U-shaped and reflects a similar interplay between funding requirements and the availability of internal funds. These results enrich our understanding of the pecking order theory.