Temporary vs. Permanent Shocks: Explaining Corporate Financial Policies

Abstract

We investigate corporate financial policies in the presence of both temporary and permanent shocks to firms' cash flows. In our framework firms can experience negative cash flows, the changes in and levels of cash flows are imperfectly correlated with firm value, and earnings volatility is different from asset volatility. These results are consistent with empirical stylized facts and are opposite to the implications of existing dynamic capital structure models which allow only for permanent shocks to cash flows. Our results show that temporary shocks increase the importance of financial flexibility and may provide an intuitively simple and realistic explanation of empirically observed financial conservatism and low leverage phenomena. The theoretical framework developed in this paper is general enough to be used in various corporate finance applications.