The firm's leverage-cash flow relationship

Abstract

Two separate strands of the literature on capital structure under asymmetric information consider the relationship between a firm's financial leverage and cash flow. Signalling theory suggests a positive relationship, while pecking order behavior implies a negative relationship. These contrasting theoretical implications appear contradictory. However, both are supported in different bodies of empirical literature. Leverage-changing event studies tend to support a positive relationship while cross-sectional studies typically reveal a negative relationship. This paper proposes that the appropriate pecking order relationship is contemporaneous — between current leverage and current cash flow, while the relevant signalling relationship is intertemporal-between current leverage and future cash flow. A dynamic simultaneous equations model is built which allows the firm's leverage, cash flow, and risk to interact jointly in the same period, as well as across time. Empirical results reveal that, in the same time period, leverage and cash flow tend to be negatively related, while across time leverage is positively related to future cash flow. Thus the apparent contradictions in the theoretical and empirical literature may be reconciled by considering both the contemporaneous and dynamic aspects of the firm's leverage/cash flow relationship.