Strategic Adjustment of Capital Structure: Evidence from S&P 500 Index Additions

Abstract

We examine the capital structure of firms that are newly added to the S&P 500 index. Leverage gradually decreases during the two-year pre-addition period and then increases during the two-year post-addition period, resulting in a U-shaped trend. This trend is more pronounced in financially weak firms and firms facing intense competition for index addition. A similar U-shaped leverage trend exists among firms that compete for addition to the index but not among firms that do not compete for addition that are otherwise similar to added firms. The sharp shift in the direction of the leverage trend after addition is attributable mainly to increases in debt issuance and cannot be explained by mechanical mean reversion of leverage or changes in the cost of capital. The overall results are consistent with firms' strategically reducing leverage to improve financial health temporarily prior to index revisions.