Financial Flexibility, Firm Size and Capital

Structure∗

by

Soku ByounHankamer School of Business

Baylor UniversityOne Bear Place 98004

Waco, TX 76798Tel: (254) 710–7849Fax: (710) 710-1092

Email: Soku Byoun@Baylor.edu

October 2007(Preliminary results. Do not quote without author’s permission.

Comments are welcome.)

∗We would like to thank the GAMF. We appreciate the support for this project that was provided bythe Hankamer School of Business at Baylor University.

Financial Flexibility, Firm Size and Capital Structure

Abstract

We examine financial flexibility as an alternative explanation to existing capital structure

theories. The financial flexibility hypothesis suggest non-linear inverted V-shape relation-

ship between leverage ratio and firm size. Consistent with this prediction, we find that

small firms have lower leverage ratios, not because of internally generated funds (as implied

by the pecking order theory) but because of additional equity financing (consistent with our

financial flexibility hypothesis). On the other hand large firms have low leverage because

they rely on internally generated fund. This finding can not be explained by either the

pecking order theory or the tradeoff theory; the pecking order may be reversed for small

firms that prefer external equity to debt financing, while the tradeoff theory may miss some

important aspects of capital structure decisions. The financial flexibility hypothesis suggest

that small firms maintain low leverage by issuing equity and building up cash holdings for

financial flexibility. Debt covenants often carry restrictions on financing and investment

decisions that are especially cumbersome for small, growing firms. Equity financing allows

small firms to raise cash without impeding financial flexibility. We find supporting evidence.

We also find that the positive relationship between firm size and leverage ratio found in

previous studies holds only for small firms, but there is a clear negative relationship for

large firms, supporting the financial flexibility hypothesis.

JEL Classification: G32

Keywords: Financial Flexibility; Trade-off theory; Pecking-order theory

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I. Introduction

Empirical studies on capital structure find a positive relationship between firm size and

leverage.1 Suggested explanations in the literature include: large firms tend to have more

leverage perhaps because they are more transparent; have lower asset volatility; are more

diversified; naturally sell large enough debt issues so that the fixed costs of public borrowing

are not prohibitive; have lower probability of default and lower financial distress costs. On

the other hand, small firms incur higher costs of issuing debt because they are more likely

to be growing firms with volatile cash flows and hence have less access to debt capital

than do large firms. Further, the costs of financial distress are likely to be particularly

severe for small firms because much of their value comes from growth options whose value

depreciates rapidly if the firm experiences financial distress. In addition, small firms have

a large fraction of their assets that are firm specific or intangible, limiting their value as

collateral.

We suggest the desire for “financial flexibility” as an alternative explanation for small

firms’ low leverage. By taking firms’ financial choices to be the outcome of the interplay

between today’s capital demand and future supply of capital, we are able to explain some

of the unexplained empirical regularities: e.g., why the pecking order theory of financing

appears to break down for small risky firms (Frank and Goyal, 2003), why firms issue too

much equity (Frank and Goyal, 2003) at the wrong times (Fama and French 2004, and

Leary and Roberts, 2005), and why there is a negative relationship between firm size and

leverage ratio (Faulkender and Petersen (2006)).

Given that small firms grow faster than large firms (Evans (1987)), there are two al-

ternative explanations for small firms to have lower leverage; by financing their growth

exclusively through retained earnings or through external equity. Most explanations for

the positive relationship between firm size and leverage assume implicitly or explicitly that

1 For example, see Titman and Wessels (1988), Rajan and Zingales (1995), Graham,Lemmon, and Schallheim (1998), Hovakimain, Opler, and Titman, (2001), Booth et al.(2001) and Fama and French (2002). However, Faulkender and Petersen (2006) find a weakor negative relationship between the leverage and firm size.

1

external equity is prohibitively expensive for small firms and hence small firms’ financing

should come exclusively from internal funds.2 There is also evidence that firms prefer in-

ternal financing to external financing.3 According to the pecking order theory (Myers and

Majluf (1984)), adverse selection costs of external equity are much greater than those of

debt. Issuance costs are also much greater for equity than for debt.4 Facing such high

adverse selection/transaction costs, small firms should avoid issuing equity by all means.

Hence, the literature has paid little attention to the potential role of external equity in

relaxing financial constraints of small firms in debt financing.

We argue that small firms with lack of financial flexibility maintain low leverage by rely-

ing on external equity financing. Financial flexibility is desired in order to handle financial

uncertainties in the future. Here the future orientation is critical; financial flexibility concern

arises from a formal decision problem in which the financial choices in the future are af-

fected by the financial choices made today. In other words, financial flexibility is a property

of today’s financial decisions that affect the options management will have in response to

unforeseeable future changes. Thus, our study is distinguished from most previous studies

which focus on how current or past shocks affect firms’ financial decisions.

Even though financial flexibility is very important for a firm to respond optimally to

future changes, it would be fundamentally inappropriate to maximize financial flexibil-

ity. Therefore, we define financial flexibility as the extent to which a firm can mobilize its

financial resources to take preventive and exploitive actions in response to subsequent in-

formation in order to maximize the firm value. According to this view, the optimal capital

structure from the static point of view may not be “optimal” once financial flexibility, i.e.,

the interplay between today’s financial decisions and future financial decisions, is taken into

2 See, for example, Frank and Goyal (2003), Leary and Roberts (2005), Strebulaev (2006),and Kurshev and Strebulaev (2006) for such arguments.

3 See Hovakimian, Opler, and Titman (2001) and Hovakimian, Hovakimian, and Tehra-nian (2004).

4 Altinkilic and Hansen (2000) find that equity issuing costs are on average 5.38% of theissue proceeds while debt issuing costs are on average 1.09%. Leary and Roberts (2005)also report significantly larger equity issuance costs.

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account.

In order to examine the importance of “financial flexibility hypothesis” in financial

decisions, we focus on firms’ decisions on cash holdings and debt/equity financing which

are the main sources of financial flexibility (DeAngelo and DeAngelo (2006)). Firms lacking

in financial flexibility would increase cash holdings while reducing leverage ratios. Even

though we consider the dividend policy in relation to financial flexibility, we do not take it

as a source of financial flexibility but rather as the decision following from having ample

flexibility. Thus, the dividend policy is taken as an identifier of a firm’s flexibility. We also

consider firm size, retained earnings and long-term credit ratings as interrelated measures of

the firm’s financial flexibility. Small growing firms typically have high demand for financial

flexibility and have accumulated less profits than large firms, causing them to concern for

financial flexibility. For example, small firms with accumulated losses (measured by retained

earnings) are likely to have little financial flexibility and debt capacity but ample need for

additional cash. Our main hypothesis is that small firms with negative retained earnings

are more likely to issue equity to build up cash holdings and preserve debt capacity for

financial flexibility and hence will have low leverage. A corollary to this hypothesis is that

cash holdings will be negatively associated with leverage. We find supporting evidence for

these predictions.

On the other hand, large mature firms with ample retained earnings are almost self-

financing and have low leverage. Thus, their large cash flows are subject to opportu-

nity/agency costs of free cash flow (Jensen and Meckling (1976)). Increasing debt financing

may address the free cash flow problem but it may reduce financial flexibility to cope with

future uncertainties. Thus, they prefer paying dividends in order to preserve debt capacity

while reducing free cash flow. This implies that large firms with ample retained earnings

also have lower leverage.

The important implication of the financial flexibility hypothesis is that there is a negative

relationship between firm size and leverage ratio, conditional on negative retained earnings,

whereas there a positive relationship between firm size and leverage ratio, conditional on

positive retained earnings.

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We find that low leverage for small firms results from external equity financing rather

than internal funds. While small firms avoid debt financing, they are much more active

in tapping into external equity capital. Firms with negative retained earnings have lower

leverage ratios and issue several times more equity than firms with positive retained earn-

ings. We also find that small firms with negative retained earnings have more cash holdings

than other firms. Thus, our findings are consistent with the argument that small firms

build financial flexibility by increasing cash holdings and equity financing to cope with

their earnings shortfalls.

We further show that firm size has an overall strong and significant positive association

with leverage ratios. However, the positive relationship between firm size and leverage

ratios is reversed for large firms when we re-estimate regressions for firms divided by size,

consistent with our financial flexibility hypothesis. We also find that negative retained

earnings are negatively associated with leverage ratio, suggesting that firms with negative

retained earnings are issuing more equity. On the other hand, positive retained positive

retained earnings are significantly and negatively associated with leverage ratios. Thus, our

results show that firms with large negative retained earnings build up cash holdings through

equity financing in order to preserve financial flexibility, whereas firms with more positive

retained earnings maintain lower leverage ratios by relying on internally generated equity

financing and financial flexibility. Overall, the results show strong support for the financial

flexibility hypothesis.

Our study brings new evidence to bear on an important issue in the capital structure

literature. The literature has wrestled with the problem of sorting out the effects of adverse

selection costs of asymmetric information on capital structure.5 On the one hand, the

literature finds that larger firms appear to provide a better fit for the pecking order theory

(Shyam-Sunder and Myers (1999) and Frank and Goyal (2003)) despite the fact that large

5 For example, see Myers and Majluf (1984), Viswanath (1993), Chang and Dasgupta(2003), and Lemmon and Zender (2004) under the pecking order framework, and Frankand Goyal (2003), Fama and French (2002), Barclay and Smith (2005), Leary and Roberts(2005), Leary and Roberts (2005a), Strebulaev (2006) and Byoun (2007) under the tradeoffframework.

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firms are less subject to information asymmetry than small firms. Our finding suggests that

large firms prefer using internal funds to preserve financial flexibility. On the other hand,

our results show that small firms issue equity and increase cash holdings despite having

low leverage in order to cope with the lack of financial flexibility. Lemmon and Zender

(2004) argue that equity issuers are prevented from issuing debt because of concerns over

financial distress or financial slack for future investment. This justification is essentially in

the same vein as our financial flexibility argument which does not require the presence of

asymmetric information. Further, Fama and French (2002) and Leary and Roberts (2005a)

show that firms are more likely to use external equity as investment increases and/or cash

flow decreases but the majority of equity financings occur when firms still have sufficient

debt capacity to fill their investment needs. Their findings are also consistent with the

financial flexibility argument.

As an explanation for violating the financing hierarchy specified by the pecking order

theory, Fama and French (2005) and Leary and Roberts (2005a) suggest that firms are

able to issue securities in a manner that avoids the adverse selection costs associated with

information asymmetry. Alternatively, managers may time the market when information

asymmetry and the corresponding costs are low so that deviations from the hierarchy do

not incur a significant penalty.6 Our findings suggest that the external financing hierarchy

suggested by the pecking order theory is reversed for small firms due to the concern for

financial flexibility. Consistent with our evidence, the findings in Byoun (2007a) suggest

that small firms become debt-free by having raised much external equity while having

reduced debt and paid large dividends.

In conclusion, asymmetric information falls short of providing a plausible explanation for

motivation behind firms’ external financing decisions. A more comprehensive explanation

should include the benefits and costs of financial flexibility, which may require a substantial

6 Rajan and Zingales (1995), Jung, Kim, and Stulz (1996), Pagano, Panetta, and Zingales(1998), Hovakimian, Opler, and Titman (2001), Baker and Wurgler (2002), and Learyand Roberts (2005a)) examine managers’ market-timing attempts. The survey results inGraham and Harvey (2001) suggest that managers issue equity following an increase instock price.

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alteration to the traditional tradeoff argument. The rest of the paper proceeds as follows:

Section II provides a literature review and discusses the concept of financial flexibility.

Section III develops financial flexibility hypotheses. Section IV describes the data. Section

V provides the estimation results and Section V concluding remarks.

II. A Literature Review and the Concept of Financial Flexibility

Despite managers’ contention that financial flexibility is an important factor in their

decision-making process,7 the capital structure literature has to date remained aloof to

recognize financial flexibility as a potentially important factor in explaining firms’ capital

structure decisions. Frank and Goyal (2005) reason, “the stress on financial flexibility is

interesting, but potentially open to a variety of interpretations. In our view the survey

evidence is of interest, but it is best regarded as being interesting and suggestive, rather

than providing definitive tests.” In addition to considerable ambiguity in the use of the

term, judgments about financial flexibility are subjective and informal and flexibility levels

are rarely monitored or even measured. Accordingly, dealing with financial flexibility may

be criticized as being less than practical and based on speculation on the ability of a firm to

respond to hypothetical future events. It is therefore not surprising that there is relatively

little systematic study of financial flexibility in the capital structure literature.8

Financial flexibility is distinguished from “financial slack.” Firms facing an adverse

selection problem desire financial slack in order to avoid the need for external funds in the

future, whereas financial flexibility is desired in order to handle uncertainties and variations

in both internal and external environments. Thus, finding that managers value financial

flexibility is not sufficient to prove that the pecking-order model is the true description of

7 The survey results of Graham and Harvey (2001), Bancel and Mittoo (2004), andBrounen et al. (2004) show that corporate managers explicitly express that they are mostlyconcerned about “financial flexibility” in their capital structure decisions.

8 In contrast, a branch of real options literature has been developed to deal with “in-vestment flexibility.” Gamba and Triantis (2005) note that most real options models aredesigned to measure the value of “investment flexibility” under the assumption of perfect“financial flexibility.”

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capital structure choice (Opler et al., 1999). Graham and Harvey (2001) make this point

explicit:

The most important item affecting corporate debt decisions is management’s

desire for “financial flexibility,”... However, the importance of flexibility in the

survey responses is not related to informational asymmetry (size or dividend

payout) or growth options in the manner suggested by the pecking-order theory.

In fact, flexibility is statistically more important for dividend-paying firms, op-

posite the theoretical prediction (if dividend-paying firms have relatively little

informational asymmetry). Therefore, a deeper investigation indicates that the

desire for financial flexibility is not driven by the factors behind the pecking-

order theory.

Graham Harvey (2001) see financial flexibility as “preserving debt capacity to make future

expansions and acquisitions” or “minimizing interest obligations, so that they do not need to

shrink their business in case of an economic down turn.” Gamba and Triantis (2005), in their

attempt to model the value of financial flexibility, define, financial flexibility as “the ability

of a firm to access and restructure its financing with low transaction costs.” They further

elaborate by adding that “financially flexible firms are able to avoid financial distress in the

face of negative shocks, and to fund investment at low cost when profitable opportunities

arise.” Donaldson (1969, 1971) uses “financial mobility” to describe “the capacity to redirect

the use of financial resources in a manner consistent with the evolving goals of management

as it responds to new information about the company and its environment.” Donaldson

particularly relates financial mobility to capital structure decisions where the goal is to find

the optimal mix of financing sources.

Heath (1978) describes a financially flexible firm as one that can take corrective action

that will eliminate an excess of required cash payments over expected cash receipts quickly

and with minor adverse effect on its present and future earnings or on the market value of

its stock. The American Institute of Certified Public Accountants (AICPA, 1993) adopts

Heath’s view by defining financial flexibility as “the ability to take action that will eliminate

an excess of required and expected cash payments over expected resources.” The Financial

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Accounting Standards Board’s (FASB) defines financial flexibility as “the ability of an entity

to take effective actions to alter amounts and timing of cash flows so it can respond to

unexpected needs and opportunities.” Most treatments of financial flexibility in the finance

literature are more or less about the ability of a firm to meet its unexpected future needs

through large cash holdings, large unused borrowing capabilities, or large liquid assets.

There are other views from different functional areas of business (See Koornhof (1998)

for a review). For example, the importance of flexibility in a firm is well recognized in

management and organization literature. Bueno-Campos (1992), Ahmed et al. (1996),

Albizu-Gallastegui (1997), Hitt et al. (1998) and Volberda (1998) define “flexibility” as

the ability to deliver cost-efficient responses quickly to changes in the business environment

and to adapt and anticipate changes that affect the goals of firms. Bernstein (1993) defines

flexibility as the ability of an enterprise to take steps to counter unexpected interruptions

in the flow of funds for reasons however unexpected. Koornhof (1998) defines flexibility as

an ability to take actions in order to reposition the resources and functions of the organiza-

tion to new information and environment in a manner consistent with the evolving vision,

strategies and goals of management. In this view, financial flexibility means the ability to

borrow from a variety of sources, to raise equity capital, to sell and redeploy assets, and to

adjust the level and the direction of operations in order to meet changing circumstances.

The various definitions of flexibility as addressed in the literatures recognizes the “re-

active” or “preventive” nature of flexibility, while failing to include the “exploitive” nature

of flexibility for uncertain competitiveness or opportunities. The combination of preventive

and exploitive nature of flexibility is more evident in Volberda (1998) who views flexibility

in two different perspectives: internal flexibility as the firm’s capacity to adapt to the de-

mands of the environment, while external flexibility as the firm’s capacity to influence their

environment and thereby reduce their vulnerability.

Actions initiated ahead of time are typically taken not only in anticipation of certain

events but also in an attempt to change the rules of the game. When expectations are not

met, or when events occur that have not been predicted, a firm may require flexibility after

the fact. In these cases, flexibility is needed to deal with uncertain obstacles or to capitalize

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on an unexpected opportunity. Actions taken ahead of time, even in the absence of a specific

need, can create options that can be used at a later stage. When a new product unexpectedly

becomes an industry standard (e.g., Apple’s iPod), resulting in a rapid expansion of the

market demand, exploitive maneuvers are important to focus financial resources in order to

rapidly capitalize on the new opportunity.

The most basic form of financial flexibility may be described in terms of the amount or

the number of financial resources available in the future. However, many of the actions taken

today for future financial flexibility can be very costly. Thus, it would be fundamentally

inappropriate for a firm to maximize financial flexibility. A more intuitive measure of

financial flexibility may be described as a firm’s financial ability to respond optimally to

future changes at lower costs. In many situations, however, we may not meaningfully

separate the cost related to such a decision. Eventually, maximizing the firm value should

be the ultimate goal of optimizing financial flexibility. Accordingly, we define financial

flexibility as the extent to which a firm can mobilize its financial resources to take preventive

and exploitive actions in response to subsequent information in order to maximize the firm

value.

It is apparent that certain aspects of financial flexibility have been noted and addressed

in the capital structure literature. For example, Donaldson (1969) observes that managers

do not follow the optimizing principle proposed by the tradeoff theory of optimal capital

structure. Instead he finds that managers concentrate on the amount of debt not in use.

Goldstein, Ju, and Leland (2001) note that a firm with low leverage today preserves the

subsequent option to increase leverage. Byoun (2007) finds evidence that firms preserve bor-

rowing capacity to finance future investment or growth opportunities. Graham (2000) shows

that firms preserve debt capacity to make future expansions and acquisitions. DeAngelo,

DeAngelo and Stulz (2007) document evidence that firms issue stock to cope with “liquidity

squeeze,” a near-term need for cash. McLean (2007) shows that firms keep equity issuance

proceeds as cash as ”precautionary motives.” Motyka, Leuca, and Fawson (2005) also find

that financial institutions hold excess liquidity to cope with the unpredictable nature of loss

(infrequent but high impact risk) in order to achieve a competitive advantage for aggressive

9

pricing and better margins. Kale and Shahrur (2007) show that firms have lower leverage

in consideration of relationship-specific investments by the firm’s stakeholders. Parsons and

Titman (2007) provides a review on how a firm’s financial condition influences strategic

decisions by both the firm and its stakeholders. DeAngelo and DeAngelo (2006) argues

that firms maintain low leverage and high dividend payouts in “normal” periods to preserve

the firm’s option to borrow or issue equity in the future opportunities.

III. Firms’ Financial Flexibility: Hypothesis Development

The need for financial flexibility arises to deal with anticipated yet unforeseeable

future financial constraints. Developing testable hypotheses in relation to financial flexibility

is complicated since we need to consider not only the interactions of firms’ financial choices

but also the interplay of current decisions with future ones.

DeAngelo and DeAngelo (2006) argue that firms can develop potential sources of finan-

cial flexibility through cash accumulation, the preservation of debt capacity, and dividend

payouts. We expect that firms with a greater need for financial flexibility hold more cash,

less debt (issue more equity) and pay less dividend. Large cash holdings increase finan-

cial flexibility for the future but incur higher costs. In addition to the opportunity costs

foregone, they are exposed to a risk of inefficient uses when the firm does not have enough

investment opportunities. Financially flexible firms can pay out its free cash flow as div-

idend or repurchase securities to minimize its opportunity/agency costs. Debt financing

provides the benefits of tax savings and reduced agency costs of free cash flow but reduces

future financial flexibility. External equity financing incurs higher issuing costs but provides

greater flexibility than debt financing. Thus, growing firms with lack of financial flexibility

prefer equity financing.

Given these financial choices available for the firm to address financial flexibility con-

cerns, we develop hypotheses that predict their impacts on capital structure decisions. The

interactions among these financial choices and with investment decision are interesting but

we limit our focus to capital structure decisions in order to have a manageable scope of

the study. Thus, our objective is to examine how the various degree of financial flexibility

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affects capital structure decisions by identifying firms that are likely or not likely to face

future financing constraints. In practice, however, the dividend and investment policies

may also be altered in the long run to mitigate financial constraint. For example, a firm

may invest in safe and liquid investments rather than in risk ones (Almeida et. al. (2006))

or alter the dividend policy, when facing financial constraints and running out of other

financial resources. However, firms are less likely to alter their investment and dividend

policies when they have other sources of financial flexibility such as cash holdings and debt

capacity. Accordingly, for the purpose of investigating the effect of financial flexibility on

the capital structure decision, we assume that firms make financing decisions in order to

accommodate future investment opportunities. Similarly, we consider a firm’s dividend pol-

icy not as in itself the immediate source of financial flexibility but as a policy to reflect the

firm’s financial flexibility condition.

In order to understand how a financial flexibility concern affects a firm’s financial deci-

sions, suppose a firm with a constant optimal debt ratio (debt/assets) of 0.5 currently has

$200 financial surplus with uncertain financing needs in the next few years. In order to pre-

serve financial flexibility for the unforeseeable future financing needs, the firm should make

financial decisions today. Considering costs and benefits, suppose the firm set the “optimal”

financing plan of raising $300 by next period (shown as negative numbers at t = 1) as follows:

Surplus = $200Debt = $400Assets = $1000

t = 0 1

-$300

The firm’s current debt ratio is 0.4. The static target adjustment model predicts that the

firm will use the current financial surplus to repurchase equity and then issue $150 debt and

$150 equity in the next period in order to maintain the optimal debt ratio of 0.5. However,

if the transaction costs of repurchasing and reissuing equity are greater than those of debt,

the firm will reduce debt rather than equity with the surplus cash and preserve the debt

capacity (as financial flexibility) for the future financing need despite the below-target debt

ratio. Or the firm may hold all or some of the surplus in order to use it in the next period, as

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long as the opportunity/agency costs of cash holdings are lower than the costs of reducing

and reissuing debt or equity.

Only firms with no financing needs in the foreseeable future may repurchase equity to

adjust toward the target debt ratio. In the above example, assuming it is cost efficient

for the firm to keep its surplus cash for the financing plan, it still requires $100 additional

equity in order to obtain the optimal debt ratio with the plan. Knowing that they will

need to issue additional equity, managers may attempt to issue equity today if they believe

today’s market condition is better than what is expected in the future. If the firm issues

equity in the above example, then the equity issuance proceeds will be kept as cash (see Kim

and Weisbach (2007) for evidence of firms’ such behavior). This will make the firm look

inconsiderate about its capital structure as well as cash holdings since it is still issuing equity

with a below-target debt ratio and ample cash balance. Indeed, Leary and Roberts (2004)

find that most equity issuances occur when firms have sufficient debt capacity, “without

any apparent risk of entering financial distress from issuing debt.” They conclude that the

decision rule that firms use to access external capital markets is unclear. Welch (2004) also

observe that firms do not use their issuing activities to counteract the external and large

influences of stock returns on their capital structures. These “puzzles” may be explained

not through the firm’s reaction to the current financial information but through its financial

flexibility concern to cope with future financial constraints and uncertainties.

We consider firm size, dividend payout, retained earnings and long-term credit ratings

as measures of firms’ various degree of financial flexibility. We put these financial flexibility

measures together to make consistent predictions in the framework of financial flexibility.

Small firms are more likely to be growing firms with more future investment opportunities,

less credit history and less internal funds available. Thus, small firms are expected to be in

need for more financial flexibility than large firms.

Retained earnings are the accumulation of a firm’s reinvested profits over time. DeAn-

gelo, DeAngelo, and Stulz (2005, 2007) argue that retained earnings measure a firm’s life-

cycle stage; firms with low retained earnings relative to total assets (or total equity) tend

to be in the capital infusion stage, whereas firms with greater retained earnings tend to be

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more mature with ample cumulative profits that make them largely self-financing. Large

cash holdings for a mature firm are exposed to a risk of inefficient uses when the firm does

not have enough investment opportunities. Issuing debt reduces the agency costs, but it

reduces financial flexibility as well. On the other hand, dividend payouts reduce the agency

costs of free cash flow (Easterbrook (1984)) without reducing financial flexibility. Thus,

large firms with greater retained earnings tend to be more mature with ample cumulative

profits and are likely to pay dividends (DeAngelo, DeAngelo, and Stulz (2005)) and pre-

serve financial flexibility through low leverage while limiting agency costs on cash balances

(DeAngelo and DeAngelo (2006)). With positive earnings, small growth firms still lacking

in their financial resources are likely to invest them in their growth options or hold them as

cash for future financing needs since they are less subject to the agency costs of free cash

flow. Overall, we propose that large mature firms with positive retained earnings maintain

lower leverage, lower cash holdings and high dividend payouts than small firms with positive

retained earnings (proposition 1).

Negative retained earnings reflect firms’ earnings shortfalls over time. To the extent that

a firm’s retained earnings are the proxy for its life-cycle stage, we expect small firms with

negative retained earnings are in the greatest need of financial flexibility. For small growing

firms with little financial flexibility, facing shortfalls in cash flow over time, even a little debt

may cause them to be in financial distress. The limitation on debt issuance that results

from the risk of asset substitution (Jensen and Meckling (1976)) are more important for

such firms. Firms with accumulated losses without financial flexibility lack investible funds

for their profitable investments and hence sources of free cash flow tend to be relatively low

for them, and thus reducing the benefit of debt that limits the scope of overinvestment and

perquisites by managers (Jensen (1986), Stulz (1990) and DeAngelo and DeAngelo (2006)).

Hence debt is less helpful both in providing capital and in reducing the costs of free cash

flow for these firms. Further, debt financing renders firms with little financial flexibility

vulnerable to predatory strategies such as price wars by established firms to exhaust less-

flexible firms financially (Poitevin (1989)), thus further deteriorating financial flexibility.

In addition, debt covenants often carry restrictions on financing and investment decisions

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that are especially cumbersome for firms with lack of financial flexibility. In short, growing

firms with negative retained earnings are constrained in borrowing. At the same time,

they face little concern for agency costs of free cash flow. Thus, they can accumulate cash

holdings through equity financing in order to increase financial flexibility. Equity issues

neither require collateral or restrictive covenants, nor accentuate moral hazard problems

that are associated with leverage, nor raise the probability of financial distress. Thus,

equity financing provides greater financial flexibility than debt financing for less flexible

firms such as small firms with negative retained earnings. Accordingly, we suggest that

small growing firms with large negative retained earnings issue more equity, maintain lower

leverage, have higher cash holdings and pay no dividend(proposition 2).

Thus, propositions 1 and 2 imply lower leverage ratios for both small growth firms and

large mature firms, but for different reasons; while large mature firms have been able to

finance most their investments with the greatest financial flexibility through internal equity

funds, small growing firms have been relying on external equity to preserve financial flex-

ibility for the future. Between these flexibility-sufficient and flexibility-deprived firms are

medium firms with mediocre retained earning that are still in much need of external financ-

ing. Medium firms generating some positive earnings have better financial flexibility than

firms struggling with negative earnings and are able to use debt financing. Also, firms with

built-up financial flexibility will use up their financial resources such as debt capacity and

accumulated cash when they face “abnormal” periods characterized by earnings shortfalls

over time ((DeAngelo and DeAngelo (2006)). Only when these firms run out of cash and

debt capacity, they will turn to equity financing. Based on these arguments, we propose

the following “financial flexibility hypothesis.”

The Financial Flexibility Hypothesis Small growing firms and firms with

large negative retained earnings are in the most need of financial flexibil-

ity and they issue more equity, maintain lower leverage ratios, have higher

cash holdings and pay no dividend. Medium firms and firms with mediocre

retained earnings have some flexibility to issue debt and meet their capi-

tal needs. Large firms and firms with large retained earnings are the most

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financially flexible as they maintain lower leverage ratios, lower cash hold-

ings and high dividend payouts.

We summarize specific predictions based on the implications of the financial flexibility hy-

potheses in Table I. The hypothesis states that firms with large positive retained earnings

are more likely to pay dividend (consistent with the findings in DeAngelo, DeAngelo, and

Stulz (2005)), while limiting debt financing. This implies a negative relationship between

leverage ratio and dividend payout, consistent with evidence documented in previous stud-

ies (Graham (2000), Frank and Goyal (2003), Minton and Wruck (2001) and Byoun (2007)).

However, non-dividend-paying firms are most likely firms with low or negative retained earn-

ings and we expect lower leverage for such firms. Thus, the relationship between leverage

ratio and dividend payout is not clear within non-paying firms.

The novelty of the financial flexibility hypothesis is its prediction of non-linear (inverted

V-shaped) relationships between firm size and leverage ratio as well as between retained

earnings and leverage ratio. The hypothesis implies that there is a positive relationship

between retained earnings and leverage ratio conditional on negative retained earnings, while

there is a negative relationship between retained earnings and leverage ratio conditional on

positive retained earnings. Also, the hypothesis states that small firms or firms with negative

retained earnings are more likely to issue equity, implying a positive relationship between

firm size and leverage ratio, conditional on negative retained earnings. However, conditional

on positive retained earnings, there is a negative relationships between firm size and leverage

ratio. This prediction is contrary to the general finding in the literature, but consistent with

the finding in Faulkender and Petersen (2006) who report a negative relationship between

firm size and leverage ratio when they consider a sample of firms only with credit ratings.

According to the financial flexibility hypothesis, large firms with positive retained earnings

are most likely to use only safe debt and hence have better long-term credit ratings. Thus,

the contradictory results regarding the relationship between firm size and leverage can be

explained by the financial flexibility hypothesis.

Faulkender and Petersen (2006) argue that market frictions may cause firms to be ra-

tioned by their lenders, leading some firms to appear under-levered relative to unconstrained

15

firms. They use firms’ long-term credit ratings as a measure of accessibility to the public

debt markets (see also Lemmon and Zender (2004) and Byoun (2007a). The market friction

argument may imply that firms with better credit ratings should use more leverage than

those with worse credit ratings. However, according to our hypotheses, large mature firms

with large retained earnings use only safe debt and as a result have better credit ratings. We

expect that good credit ratings are associated with large mature firms with lower leverage.

Thus, contrary to the implication of the market friction argument, we expect a negative re-

lationship between leverage and credit ratings, conditional on having credit ratings. On the

other hand, given that small firms with negative retained earnings are least likely to have

credit ratings, we expect a lower leverage for firms with no credit ratings than for those with

ratings and hence a positive relationship between leverage ratio and firms size, conditional

on no credit ratings. The financial flexibility hypothesis also implies a negative relationship

between leverage ratio and cash holdings as firms with lack of financial flexibility increase

cash reserves through equity issues.

Firms’ preference for financial flexibility generally depends on the uncertainty around

expected earnings and investment opportunities. Issuing risky debt implies the firm loses its

financial flexibility. Firms with greater needs for financial flexibility should issue safe debt

whose payments are covered by earnings next period. Firms with less expected earnings or

much uncertainty about the earnings will be better off issuing equity and/or maintaining

high cash balances since issuing equity in the event of a low-profit outcome in the future will

bear prohibitively high issuing costs for the firm. Thus, if the probability of low earnings is

high, the firm with lack of financial flexibility will abstain from issuing risky debt. Consis-

tent with this argument, firms appear issuing equity before declining earnings (McLaughlin,

Safieddine, and Vasudevan (1996), Loughran and Ritter (1997) and Hansen and Crutchley

(1990)). The demand for financial flexibility will also increase with expected investment

opportunities and their uncertainties since future capital needs are more likely to create

financial constraints. Only firms with high probability of great earnings and less expected

investment opportunities can safely borrow more against the anticipated profits. In that

case, large cash holdings incur high opportunity/agency costs without obtaining greater

16

financial flexibility. Accordingly, we expect that expected earnings (expected investment

opportunities) will be associated positively (negatively) with leverage and negatively (pos-

itively) with cash holdings, consistent with the documented findings in the literature. We

examine these predictions as well.

IV. Data

The initial sample consists of all available U.S. firms for the period of 1971–2005

from the annual Compustat files. Following previous studies, we exclude financial firms and

regulated utilities from the sample.9 We also require firms to have positive total assets,

book and market value of equity and net sales. These variables are used to deflate other

variables and it is difficult to interpret the results when they have non-positive values.

We also delete observations with missing or non-positive values for the number of shares

outstanding and stock price at the end of the fiscal year. Accordingly, we drop bout 8 %

of firm-year observations in the sample that does not meet these requirements. After these

initial requirements are applied, the sample consists of 179,418 firm-year observations.

While Shyam-Sunder and Myers (1999) and Myers (1984) argue that there are rational

reasons for managers to specify debt targets in terms of book values, Titman and Wessels

(1988) and Welch (2004) are inclined toward the use of debt level measured at market value.

Accordingly, we test our hypotheses using total and long-term debt ratios measured with

both book and market value of total assets. The definitions of all the variables used in this

study are provided in the Appendix.

9 Financial firms are represented by SIC codes 6000-6799 and utilities by SIC codes 4800-4999. These firms have very different capital structures and their financing decisions maynot convey the same information as non-financial and non-regulated firms. For example, arelatively high leverage ratio is normal for financial firms, but the same high leverage ratiofor non-financial firms may indicate possible financial distress.

17

V. Univariate Analyses

A. Firm Size, Credit Ratings and Leverage

In order to examine the relationship between firm size and leverage closely, we divide

the sample into size deciles each year and report the leverage ratios measured in long-term

and total debt to book/market value of assets.10 We delete all observations with leverage

ratios less than zero or greater than one.11 We define size in three different ways based on

book value of total assets, market value of total assets and net sales, but the results are

similar and we report only those based on the book value of total assets.

Panel A of Table II shows that regardless of the various definitions of leverage ratios,

there is a positive monotonic relationship between firm size and leverage ratio especially

for smaller size deciles. We also report the percentage of zero-debt firms in each size decile.

Small firms are associated with much more zero-debt firms than large firms. Byoun (2007a)

suggests that zero-debt firms are constrained by debt market while unconstrained by equity

market. This implies that zero-debt firms lack financial flexibility. In order to examine

whether the negative relationship between firm size and leverage ratio is driven by these

zero-debt firms, we report the results excluding zero-debt firms in Panel B of Table II.

Even though there still exists a fairly positive relationship between firm size and leverage

ratio without the zero-debt firms, the positive relationship between size and leverage ratio

became weaker for the largest three size deciles. Thus, our results confirm that there exists

strong positive relationship between firm size and leverage except for firms in the largest

three deciles in which the positive relationship is weakened or reversed.

10 The results does not change when we exclude deferred taxes and investment tax creditor include convertible debt (item 79) in the definition of book equity as in Alti (2006) andKayhan and Titman (2006).

11 Without this requirement, the average book leverage ratio of the sample firms in thefirst size decile are greater (but market leverage ratios are smaller) than firms in larger sizedeciles since there are a few firms with book leverage ratios greater than one in the firstsize decile. When we winsorize leverage ratios at 99 percentile, there still exist firms withleverage ratios greater than one.

18

Table II

In Table III, we divide the sample into prior- and post-1985 subperiods. Since S&P

credit rating information is available only from 1985, on the one hand, this allows us to

examine the distribution of rated firm across size deciles for this period. On the other

hand, it allows us to examine if there is any discernible change in the relationship between

firm size and leverage. For the period of 1971-1984, the relationship between firm size and

leverage is positive and monotonic except for market total debt ratio. On the other hand,

for the period of 1985-2005, the positive relationship holds only up to 7th deciles and the

relationship becomes weakly negative in the largest three deciles. The results also show

that small firms rarely have long-term credit ratings and most ratings are concentrated in

the largest three deciles. The sample in Faulkender and Petersen (2006) includes firms with

credit ratings that are mainly from the largest three size deciles for the period after 1985,

which may explain their finding of a negative association between firm size and leverage.

Table III

In order to explicitly examine the implication of the financial flexibility hypothesis that

there is a negative relationship between leverage and credit ratings, conditional on credit

ratings. We examine firms’ leverage ratios based on long-term credit ratings (Rating) in

Table IV. Consistent with the prediction of our hypothesis, the results show that firms with

higher credit ratings are larger firms and have lower leverage ratios, confirming a negative

relationships between credit rating and leverage ratio, conditional on having credit ratings.

There is also a negative association between firm size and leverage ratio for rated firms, but

unrated firms tend to be smaller and have lower leverage ratios on average than firms with

credit ratings.

Table IV

19

B. Firm Size, Cash Holdings, Retained Earnings, Dividends and External Fi-

nancing Activities

In order to examine weather the lower leverage for small firms results from accumulated

internal equity (as suggested by the pecking order theory) or external equity (as suggested

by the financial flexibility hypothesis), we report retained earnings, net long-term debt

issue, net total debt issue and net new equity issue as proportions of total assets. We also

examine the ratio of cash and marketable securities to total assets.12 We drop observations

with missing values in any of the reported variables.

Table V reports the results. The results in Panel A show that small firms tend to have

more cash holdings while having less retained earnings than large firms. In fact, the average

retained earnings are negative for firms in smaller size deciles. Thus, small firms’ growth is

not likely to come mainly from internally generated equity. Small firms’ long-term or total

debt financing is minuscule compared to that of large firms, while their equity financing

is phenomenal. On average firms in the first and second size deciles issue equity for 25%

and 12% of total assets per year, respectively. There are strong positive and monotonic

relationship between firm size and dividend payouts except for the first size decile firms

whose dividend payouts are greater than firms in the second size decile.

Table V

The results in Table V can be driven by IPO firms that are more likely to be in small

size deciles. In order to examine the IPO effect, we identify the IPO date from Compustat

and designate the first fiscal year ending after the IPO date as a IPO year. We also identify

the first year appearing in the Compustat for those that do not have IPO dates but the

Compustat begins its coverage during our sample period and treat it like the IPO year. The

results excluding these IPO years are reported in Panel B. They show that the magnitude

of external equity raised by small firms becomes smaller after excluding IPO years, but it

12 Including accounts receivable in addition to cash and marketable securities producesalmost identical results.

20

is still significantly greater than that raised by larger firms.

There is another possibility that the results could be driven by a few outliers especially

in small size deciles. To address this concern we reproduce results with exclusion of the

outliers of net equity financing variable at 1st and 99th percentiles. Again the results in

Panel C show that small firms heavily rely on external equity with little debt. The pattern

remains intact but only with less magnitudes when we exclude observations with greater

cutoff percentiles of the equity financing variable. The dividend payouts of the first decile

firms are greater than those in the second through fifth size deciles. Byoun (2007a) find

that small zero-debt firms pay higher cash dividends and issue much more equity than

other firms. Since zero debt firms are concentrated in the smaller size decile, the higher

average dividend payout for the first decile can be driven by zero-debt firms. Accordingly,

we estimate the average dividend payouts for non-zero debt firms without zero-debt firms

and find that the higher dividend payouts for the first decile firms are indeed due to high

dividend payouts of zero-debt firms.

Overall, firm size is negatively associated with cash holdings and equity financing and

positively associated with retained earnings, debt issue and dividend payout. Thus, small

firms have lower leverage ratios, not because of internally generated funds but because of

additional equity financing. Small firms also build up cash holdings through external equity

in order to preserve financial flexibility, consistent with our financial flexibility hypothesis.

Firm size and retained earnings are highly correlated, making it difficult to examine the

effect of retained earnings. Accordingly, we address this issue below.

C. Firm Size, Retained Earnings and Leverage

In order to disentangle the relationship between retained earning and leverage ratios

while accounting for the strong association of firm size with retained earnings, we first

examine the leverage ratios for firms divided into negative and positive retained earnings

groups within each size decile.

Panel A of Table VI shows cash holdings and leverage ratios for each group. The results

show that the smaller firms (in size deciles below 6) with negative retained earnings hold

21

more cash balances than similar size firms with positive retained earnings as a means of

preserving financial flexibility. Most differences are statistically significant except for the

first two deciles (not reported in the table). On the other hand, large firms with negative

retained earnings tend to carry less cash balances with higher leverage ratios than large

firms with positive retained earnings. Large firms appear to use preserved debt capacity

and cash balances to counteract to negative earnings shocks, consistent with our financial

flexibility hypothesis.

The market value leverage ratios for firms with negative retained earnings are always

smaller than book value leverage ratios because negative retained earnings tend to decrease

the book value of total assets. Since the portion of negative retained earnings relative to

total assets are significantly greater for small firms, smaller firms (in 1 to 4 size deciles)

with negative retained earnings have higher book leverage ratios whereas lower market-

value leverage ratios than firms with positive retained earnings in the same size deciles.

Accordingly, the relationship between firm size and leverage within smaller size deciles

(lower than decile 5) can be affected by whether the leverage is measured in book value

or market value because of the significant number of small firms with negative retained

earnings. For this reason, firms with negative retained earnings have higher book leverage

ratios despite their heavy reliance on equity financing as shown below. Thus, the higher

leverage ratios for small firms with large negative retained earning result not from debt

issues but from negative retained earnings.

Panel B of Table VI shows that within the same size decile firms with negative retained

earnings pay less dividend and issue substantially more equity than those with positive

retained earnings. For example, for deciles 2 through 7, firms with negative retained earnings

issue four to five time as much equity as the firms with positive retained earnings do. The

results suggest that larger equity issues of small firms are driven by firms with negative

retained earnings as they issue equity to raise cash as a means of of preserving financial

flexibility. Firms with negative retained earnings issue less debt than firms with positive

retained earnings in most size deciles except for the largest size decile in which the difference

is not significant. Clearly, firms with negative retained earnings issue both debt and equity,

22

but their equity issues, especially for small firms, are significantly greater than those issued

by firms with positive retained earnings. This finding is consistent with hypotheses 2 that

firms with negative retained earnings pay less dividend and issue more equity to preserve

financial flexibility.

Consistent with the financial flexibility hypothesis, the results in Table V show that

small firms with negative retained earnings hold more cash balances and pay less dividends

while issuing more equity than those with positive retained earnings as a means of preserv-

ing financial flexibility. However, large firms with negative retained earnings, while paying

less dividends and issuing more equity, have less cash balances and higher leverage ratios

than those with positive retained earnings, again consistent with the financial flexibility

hypothesis.

Table VI

D. Retained Earnings, Firm Size, Credit Ratings, Dividend and Leverage

The financial flexibility hypothesis states that firms with large negative retained earnings

use equity financing, firms with mediocre retained earnings use debt financing, and firms

with large positive retained earning use internally generated equity financing. In order to

test this, we divide the sample into deciles based on retained earnings and examine firms’

financing activities, dividend payouts and leverage ratios in Tables VII.

Table VII

We report retained earnings, total assets, and various leverage ratios for each decile in

Panel A. An examination of leverage ratio across retained earnings deciles reveals that

there is indeed a inverted V-shape relationship between retained earnings and leverage ra-

tios, consistent with the implication of the financial flexibility hypothesis. There is also

a similar inverted V-shape relationship between firm size and leverage, that is, a negative

relationship between leverage ratio and firm size across the upper five retained earnings

23

deciles and a positive relationship between leverage ratio and firm size across the other

lower deciles.

The results in Panel B provide further supporting evidence for our hypotheses. Firms

with large negative earnings in lower deciles hold the largest cash balances by issuing much

more equity than debt. Largest firms in the middle deciles (see Panel B in Table VII)

hold lowest cash balances, issuing more debt than firms in other deciles. As we move from

decile 7 to upward, we can observe that firms reduce both debt and equity financing while

increasing dividend. Firms in the largest retained earnings decile actually reduce both debt

and equity. Overall, the results in Tables VII are very intriguing and surprisingly consistent

with our financial flexibility hypotheses.

V. Multivariate Analyses

E. Estimation Results from Regression Model

In this section, we directly test the implications of the financial flexibility hypotheses

that are provided in Table I with the following regression models:

LEV = α0 + α1RE ·D+Re + α2RE ·D−Re + α3Cash+ α4LnA+ α5Div

+α6MB + α7RND + α8D0RD + α9OI

+α10MOI +Other V ariables+ ε (1)

LEV = α′0 + α′1RE ·D+Re + α′2RE ·D−Re + α′3DNo + α′4Rating

+α′5Cash+ α′6LnA+ α′7Div + α′8MB + α′9RND + α′10D0RD + α′11OI

+α12MOI +Other V ariables+ ε (2)

The detailed definition of each variable is provided in the Appendix. Equation (2) include

additional variables, a dummy variable for firms with no long-term credit ratings (DNo)

and long-term credit ratings (Rating) numbered 0 for non-rated firms and from 1 for the

lowest rating (below B) to 7 for the highest rating (AAA) (See Table IV). Since information

on credit ratings is available only from 1985, the estimation of equation (1) is restricted

24

to the sample of 1985-2005 period. The variables that are of main interest in testing the

implications of the financial flexibility hypotheses given in Section III are firm size (LnA),

the interaction variables between retained earnings (RE) and dummy variables for positive

(D+Re) and negative retained earnings (D−Re), . We expect, positive coefficient estimates

for D−Re and negative estimates for D+Re, DNo and Rating based on the signs given in

Table I. Given the inverted V-shape relationship between firm size and leverage, we expect

positive coefficient estimates for LnA within financially constrained groups such as small

size firms, firms with negative retained earnings, non-dividend paying firms, and non-rated

firms, whereas we expect negative coefficient estimates for the other non-constrained groups.

We also include dividend Div even though the as Table I also provides a negative pre-

diction for the relationship between dividend and leverage ratio, this prediction is consistent

with existing evidence. Also, expected earnings and investment opportunities need to be

proxied by some measures. Market-to-book assets ratio (MB), research and development

expenditures (RND) and a dummy variable equal to one for missing value for RND variable

(D0RD), are typically used in previous studies as measures of a firm’s investment opportu-

nities and are known to be negatively associated with leverage ratio, consistent with our

prediction. For expected earnings, we use operating income (OI) and industry median

operating income (MOI) as proxies for expected earnings.

Other variables include a dummy variable equal to one for the zero debt year (Zero),

dummy variable for IPO year (IPO), Fixed assets (FA), Altman’s Z-score (AZ), deprecia-

tion and amortization (Dep), marginal tax rate (Tax), operating income (OI) and industry

median debt ratio (Med). Following the common practice in handling the outliers in the lit-

erature, we winsorize variables at 1st and 99th percentiles except for those that are bounded

by 0 from below, in which case we winsorize only at 99th percentile.

Table VIII

Panel A in Table VIII reports two sets of estimation results for each dependent variable

for the entire time period and for the period of 1985-2005 which also includes credit rating

25

variables. The coefficient estimates on firm size (LnA) are highly significant and positive in

all regressions. Thus, there is a fairly strong positive relationship between leverage and firm

size even after controlling for the additional variables. The coefficient estimates on positive

retained earnings (RE ·D+Re) are all significant and negative as predicted by the financial

flexibility hypothesis. On the other hand, the coefficient estimates on negative retained

earnings (RED−Re) are mixed: they are significant and positive with total debt ratios but

either insignificant or negative with market value long-term debt ratio. This result could

be driven by the fact that debt ratios for firms with negative retained earnings may have

been inflated with market value debt ratio. But the coefficient estimates on RED−Re are

economically insignificant compared to those on RED+Re. This result suggests that firms

with large positive retained earnings have significantly lower leverage. Also, firms holding

more cash balances, consistent with the financial flexibility hypothesis. IPO firms and zero-

debt firms tend to have lower leverage as expected. All other variable are as expected and

consistent with previous results.

In order to further examine the non-linear relationship between firm size and leverage

ratio, conditional on those proxies for financial flexibility, we divide firm into two groups

based on each variable and estimate separate regressions. We also do this for samples

divided into before and after 1985 with and with credit rating variables. Since the results

are very similar, report to different sets of results between small and large firms in Panel

B and between rated and non-rated firms for the period of 1985-2005. For small and large

groups, we divide the sample by deciles greater than and less than or equal to decile 5.

By estimating the regressions for small and large firms separately, we can also examine the

non-linear relationship between retained earnings and leverage ratio.

The estimation results in Panel B show that the coefficient estimates on size (LnA) are

all significant and positive for small firms but negative and significant for large firms. Thus,

the positive relationship between firm size and leverage holds true only for small firms. This

finding strongly support our financial flexibility hypothesis. The coefficient estimates on

positive retained earnings (RE ·D+Re) are all significant and negative, while the coefficient

estimates on negative retained earnings (RED−Re) are all positive and significant for large

26

firms as predicted by the financial flexibility hypothesis. It appears that firm size better

represents the financial flexibility constraint for small firms while retained earnings and

firms size together seems catching large firms’ super financial flexibility. The coefficient

estimates on dividend (Div) are highly significant and negative for large firms but insignifi-

cant for small firms. Large firms with large internal funds seem paying more dividend while

maintaining low leverage, consistent with the financial flexibility hypothesis.

We report the results for groups divided by rated and unrated firms for the period of

1985-2005. Again, the results for rated firms are very consistent with our financial flexibility

hypothesis, while the results for non-rated firms give some mixed results.

Overall, the regression results show support evidence for our financial flexibility hypoth-

esis that the positive relationship between leverage ratio and firm size hold only for small

firms but there is a strong negative relationship between leverage ratio and firms size for

large firms. We find similar non-linear relationship between leverage ratio and firm size

when we divide firms based on credit rating and non-rating, dividend paying and non-

paying, or positive and negative retained earnings. This finding is very significant because

previous studies overlooked such non-linear relationship between leverage ratio and firm

size. The non-linear relationship between leverage and firm size suggest that small firms’

lower leverage ratios result from their concern for financial flexibility (issuing equity and

building up cash holdings) and large firms with positive retained earnings also have lower

leverage as they mostly rely on internal funds while preserving debt capacity.

VI. Robustness Check

IN PROGRESS

VI. Summary and Conclusions

We examine the relationship between firm size and leverage in the view of finan-

cial flexibility. We define financial flexibility as the extent to which a firm can mobilize

its financial resources to take preventive and exploitive actions in response to subsequent

information in order to maximize the firm value.

27

We hypothesize that small growing firms and firms with large negative retained earnings

are in the most need of financial flexibility and they issue more equity, maintain lower

leverage ratios, have higher cash holdings and pay no dividend. Medium firms and firms

with mediocre retained earnings have some flexibility to issue debt and meet their capital

needs. Large firms and firms with large retained earnings are the most financially flexible

as they maintain lower leverage ratios, lower cash holdings and high dividend payouts.

Consistent with our hypothesis, firms with negative retained earnings issue several times

more equity than firms with positive retained earnings. While small firms avoid debt fi-

nancing, they are much more active in tapping into external equity capital. We also find

that small firms often have negative retained earnings with no less cash holdings than other

firms and that small firms with negative retained earnings have lower leverage than firms

with positive retained earnings.

We further show that firm size has an overall strong and significant positive associa-

tion with leverage. However, the positive relationship between firm size and leverage are

reversed for large firms when we divide the firms into small and large group, credit rating

and non-rating, dividend paying and non-paying, or positive and negative retained earn-

ings. Our regression results, coupled with univariate results, suggest that small firms with

negative retained earnings build up cash holdings through equity financing, lowering lever-

age ratios, whereas large firms with positive retained earnings rely on internal equity for

their capital needs and still pay dividends resulting in lower leverage ratios. Thus, the

relationship between leverage and firm size is not linear—this is what is predicted by the

financial flexibility hypothesis. Overall, small firms have lower leverage ratios, not because

of internally generated funds or additional debt financing but because of additional equity

financing. Small firms also build up cash holdings in order to preserve financial flexibility

through external equity.

This finding can be explained by neither of the pecking order theory and the tradeoff

theory—the pecking order may be reversed for small firms that prefer external equity to

debt financing while the tradeoff theory may miss out some important aspects of capital

structure decisions. On the other hand, our study brings new insights into several unresolved

28

issues in the capital structure literature. For example, why do larger firms appear to provide

a better fit for the pecking order theory (Shyam-Sunder and Myers (1999) and Frank and

Goyal (2003)) despite the fact that large firms are less subject to information asymmetry

than small firms? Our finding suggests that large firms prefer using internal funds to

preserve financial flexibility. On the other hand, small firms issue equity and increase cash

holdings despite having low leverage in order to cope with the lack of financial flexibility,

thus reversing the external financing hierarchy suggested by the pecking order theory. This

also answers why most equity issuances occur when firms have sufficient debt capacity

(Fama and French (2002) and Leary and Roberts (2005a)), “without any apparent risk of

entering financial distress from issuing debt.”(Leary and Roberts (2004)) Our findings may

also have bearings on Welch (2004) who observe that firms do not use their issuing activities

to counteract the external and large influences of stock returns on their capital structures.

In conclusion, asymmetric information falls short of providing a plausible explanation

for motivation behind firms’ external financing decisions. The benefits and costs associated

with financial flexibility influence firms’ capital structure decisions—but not in the manner

hypothesized by the traditional trade-off theory. Thus, a substantial alteration may be

required to the tradeoff argument. Future study should address the crux of the financial

flexibility, how uncertainty affects a firm’s financial decisions.

29

Appendix. Variable Definitions

Total assets = Compustat item 6;

Net sales = item 12;

The number of shares outstanding = item 25;

Stock price at the end of the fiscal year =item 199;

Accounts receivable =item 2;

Net long-term debt issue = item 111 - item 114;

Net total debt issue = item 111 − item 114 − item 301 if item 318 = 1 and item 111

− item 114 + item 301, otherwise. Changes in current debt (item 301) represent an

increase in working capital for format code 1 but a decrease in working capital for

format codes;13 1 to 3, OCF equals item 123 + item 124 + item 125 + item 126 +

item 106 + item 213 + item 217 + item 218. For firms reporting format code 7, OCF

equals iitem 123 + item 124 + item 125 + item 126 + item 106 + item 213 + item

217 + item 314;14

13When we evaluate the Statement of Cash Flows or Changes in Financial Position for any company in

Compustat, we first consider Format Code (item 318). This is important because the format code directs us

to the data that are available for a particular company. Prior to the adoption of the Statement of Financial

Accounting Standards (SFAS) #95 for U.S. companies and currently for foreign companies, the format code

may have changed from one year to the next depending on the manner in which a company reported its

data. Effective for fiscal years ending July 15, 1988, the SFAS #95 required U.S. companies to report the

Statement of Cash Flows (format code = 7). Prior to the adoption of SFAS #95, companies had the option

of reporting any one of the following: 1) Working Capital Statement; 2) Cash Statement by Source and Use

of Funds; or 3) Cash Statement by Activity. These formats were specified beginning in 1971, which is the

reason our sample period begins with this year. (See Compustat manual.)

14Following Frank and Goyal (2003), we treat missing values that are not reported or combined with

other data items in the definition of OCF as zero.

30

Net equity issues = item 108 − item 115;

Ratio of cash and marketable securities to total assets =[item 162 + item 193] /

item 6;

AZ = Altman’s Z-score modified by MacKie-Mason (1990): (3.3EBIT (item 178) + sales

(item 12) + 1.4 retained earnings (item 36) + 1.2 working capital (item 4 - item 5))

divided by total assets (item 6). Altman’s Z-score measures the ex ante probability

of distress (Graham (1996, 2000));

Cash = Cash and short-term investments (item 1) ;

Dep = depreciation and amortization (item 14) as a proportion of total assets. Firms with

more depreciation expenses have less need for the interest deductions associated with

debt financing;

DIV = common stock dividends (item 127) divided by total assets. DIV controls for

possible trade-off between debt and dividend in reducing agency costs of free cash

flow (Fama and French (2002));

D0Div = dummy variable equal to one if the firm has missing values for common stock

dividends (item 127) and zero otherwise;

∆Eit = net equity issues for firm i from time t− 1 to t: item 108 − item 115;

FA = fixed assets (item 8) divided by total assets. Firms operating with greater tangible

assets have a higher debt capacity;

IPO = dummy variable equal to one for IPO year and zero otherwise;

LnA = log of total assets (item 6) as a measure of firm size. Larger firms tend to: have more

leverage (perhaps because they are more transparent); have lower asset volatility; or

naturally sell large enough debt issues so that the fixed costs of public borrowing are

not prohibitive;15

15The results are not affected whether the size is defined in terms of market value of assets or of net sales

31

MB = market-to-book ratio of assets. The market value of assets (MV ) equals total

assets (item 6) minus total equity (item 216) minus balance sheet deferred taxes and

investment tax credit (item 35) plus the market value of common equity (price (item

199) times shares outstanding (item 54)) plus preferred stock liquidating value (item

10, replaced by the redemption value of preferred stock (item 56) when missing).16

A higher MB is generally taken as a sign of more attractive future growth options,

which a firm tends to protect by limiting its leverage;

Med = industry median debt ratio based on two-digit SIC (or Fama and French (2002)

industry groupings). According to Frank and Goyal (2004), the industry median

leverage is an important determinant of a firm’s leverage ratio, acting as a proxy for

several factors, including intangibility, regulation, stock variance, uniqueness, pur-

chasing manager’s sentiment index, etc.;

OI = operating income (item 13) divided by total assets (item 6). A firm with higher

earnings could prefer to operate with either lower or higher leverage. Lower leverage

might occur, as higher retained earnings mechanically reduce leverage, or if the firm

limits leverage to protect the franchise responsible for producing these high earnings.

Higher leverage might reflect the firm’s ability to meet debt payments out of its

relatively high earnings cash flow;

MOI = Median industry operating income (item 13) divided by total assets (item 6) based

on two-digit SIC code;

Rating = numeritized long-term credit rating (item 280). If item 280 =2 (AAA), then

Rating = 7. If item 280 = 4 (AA+), 5 (AA) or 6 (AA−), then Rating = 6. If

item 280 = 7 (A+), 8 (A) or 9 (9A−), then Rating = 5. If item 280 = 10 (BBB+),

11 (BBB) or 12 (BBB−), then Rating = 4. If item 280 = 13 (BB+), 14 (BB) or 15

(item 12).

16The results do not change when we exclude deferred taxes and investment tax credit or include con-

vertible debt (item 79) in the definition of book equity (as in Alti (2006) and Kayhan and Titman (2006)).

32

(BB−), then Rating = 3. If item 280 = 16 (B+), 17 (B) or 18 (B−), then Rating = 2.

For all other ratings, Rating = 1. For unrated firms, Rating = 0.

DNo dummy variable equal to one if the firm has missing values long-term credit ratings

(item 280) and zero otherwise; Following Faulkender and Mitchell (2003) we use firms’

long-term credit ratings (item 280) as a measure of accessibility to the public debt

markets. Fualkender and Mitchell (2003) and Lemmon and Zender (2004) find that

leverage ratios of firms with credit ratings are significantly higher than firms without

ratings.

RE = retained earnings (item 36) divided by total assets. DeAngelo, DeAngelo, and Stulz

(2005) argue that firms with low RE/TE (RE/TA) tend to be in the capital infusion

stage, whereas firms with high RE/TE (RE/TA) tend to be more mature with ample

cumulative profits that make them largely self-financing, hence good candidates to

pay dividends. It is also a better measure of a firm’s lifecycle stage (hence suitability

to pay dividends) than its cash balances, because the source of the cash impacts the

dividend decision. For example, high cash holdings can reflect the proceeds of a recent

equity offering for a firm whose low RE/TE and RE/TA show it to be in the infusion

rather than the distribution stage;

D+Re = dummy variable equal to one for the firm with positive retained earnings (item

36) and zero otherwise;

D−Re = dummy variable equal to one for the firm with negative retained earnings (item

36) and zero otherwise;

RND = research and development expenditures (item 46) divided by net sales (item 12).

RND can be taken as a proxy for future expected investment (Fama and French

(2002)). They also serve as an additional proxy for non-debt tax shields. Following

previous studies (e.g., Opler, Pinkowitz, Stulz, and Williamson (1991), Loughran and

Ritter (1997), Fama and French (2002), Kayhan and Titman (2003) and Leary and

Roberts (2004)), we assume that missing values for the R&D variable are zero.;

33

D0RD = dummy variable that equals one for firms with missing RND and zero otherwise;

Tax = marginal tax rate equal to the statutory tax rate if the firm reports no net operating

loss carryforwards (item 52) with positive pretax return (item 170) and zero otherwise.

The statutory taxes are 48% from 1971 to 1978, 46% from 1979 to 1986, 40% in 1987,

34% from 1988 to 1992, and 35% from 1993 to 2003. Plesko (2003) shows that this

binary measure captures the marginal tax effects;

Zero = dummy variable equal to one for the year with zero debt and zero otherwise;

34

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38

Table I. Financial Flexibility Considerations and Leverage Decisions

Financial Decisions

Leverage

Firm size conditional on positive retained earnings, long-term credit rating or dividend paying.

(Theses firms are likely to use them to pay off existing debt for financial flexibility, while small firms invest in their growth option)

-

Firm size conditional on negative retained earnings, no credit rating, or no dividend paying (small firms issue equity to increase cash and lower the

leverage, while large firms utilize built-up cash and debt capacity)

+

Positive retained earnings (As a firm accumulates more positive earnings, it will increase dividend and

reduce leverage)

-

Negative retained earnings (As a firm accumulates large negative earnings, it will reduce dividend,

issue equity and hold more cash)

+

No Long-term credit rating (Firms with no credit rating are most likely to have negative retained

earnings without access to bond market and have lower leverage than firms with credit ratings)

-

Long-term credit ratings (Firms with higher credit ratings maintain low leverage than firms with lower

ratings)

-

Cash Holdings

(Firms with little flexibility hold high cash balances with low leverage)

-

Dividend (Dividend paying firms maintain low leverage)

-/+

Expected earnings (Add flexibility to firm’s financing resources allowing to hold less cash, issue

more debt and pay dividend)

+

Expected investment opportunities (Increase the need for financial flexibility)

-

Table II. Firm Size Deciles and Leverage Ratios

The data consists of 179,418 firm-year observations for the period 1971-2005. Observations with missing values in any of

the reported variables are deleted. Size is size deciles based on total assets. Book (Market) Long-term Debt is long-term

debt over book (market) value of total assets and Book (Market) Total Debt is total debt over book (market) value of total

assets. The market value of assets equals total assets minus total equity minus balance sheet deferred taxes and investment

tax credit plus the market value of common equity plus preferred stock liquidating value. % of Firms with Zero Debt is

the percentage of firms relative to the total number of firms in each size decile. A zero-debt firm is a firm with no debt.

A. All firm-year observations (179,418)

Size Decile Total Assets

Book Long-term Debt

Book Total Debt

Market Long-term Debt

Market Total Debt

% of Firms with Zero

Debt

1 3.62 0.0974 0.2074 0.0590 0.1164 0.2035

2 10.39 0.1241 0.2184 0.0943 0.1647 0.1578

3 21.66 0.1356 0.2186 0.1137 0.1828 0.1487

4 40.62 0.1452 0.2170 0.1295 0.1936 0.1480

5 71.75 0.1651 0.2286 0.1482 0.2062 0.1293

6 128.62 0.1916 0.2493 0.1687 0.2217 0.0994

7 240.64 0.2188 0.2725 0.1890 0.2378 0.0744

8 496.17 0.2437 0.2942 0.2089 0.2537 0.0445

9 1354.40 0.2476 0.2968 0.2125 0.2552 0.0299

10 15673.95 0.2387 0.3017 0.2138 0.2679 0.0063

B. Non-zero-debt firm-year observations (155,435)

Size Decile Total Assets Book Long-

term Debt Book Total

Debt Market Long-

term Debt Market Total

Debt

1 3.67 0.1223 0.2604 0.0741 0.1462

2 10.26 0.1474 0.2593 0.1120 0.1955

3 21.17 0.1593 0.2568 0.1335 0.2147

4 39.21 0.1704 0.2547 0.1520 0.2273

5 68.78 0.1896 0.2626 0.1702 0.2368

6 123.99 0.2127 0.2768 0.1873 0.2461

7 237.02 0.2364 0.2944 0.2042 0.2569

8 490.26 0.2550 0.3079 0.2187 0.2655

9 1347.74 0.2553 0.3060 0.2190 0.2630

10 15694.31 0.2402 0.3036 0.2151 0.2696

Table III. Firm Size Deciles and Leverage Ratios for Sub-periods Divided into Before and After 1985

The data consist of firm-year observations for the period 1971-2005. Observations with missing values in any of the

reported variables are deleted. Size is size deciles based on total assets. Book /Market Long-term/Total Debt is long-

term/total debt over book/market value of total assets. The market value of assets equals total assets minus total equity

minus balance sheet deferred taxes and investment tax credit plus the market value of common equity plus preferred stock

liquidating value. % of Firms with Zero Debt is the percentage of firms with no debt relative to the total number of firms

in each size decile. % of Firms with Bond Rating is the percentage of firms with long-term credit ratings relative to the

total number of firms in each size decile.

A. For 1971 – 1984 Period (53,702 Obs)

Size Decile Total

Assets Book Long-

term Debt Book Total

Debt

Market Long-term

Debt Market

Total Debt

% of Firms with Zero

Debt

1 4.19 0.1132 0.2046 0.0873 0.1525 0.1734

2 9.75 0.1481 0.2350 0.1345 0.2123 0.1034

3 17.06 0.1727 0.2552 0.1658 0.2453 0.0812

4 27.68 0.1923 0.2695 0.1939 0.2719 0.0594

5 44.14 0.2035 0.2750 0.2031 0.2754 0.0540

6 71.33 0.2193 0.2873 0.2189 0.2880 0.0352

7 122.58 0.2315 0.2941 0.2293 0.2926 0.0374

8 239.36 0.2326 0.2893 0.2322 0.2884 0.0239

9 631.22 0.2470 0.3008 0.2488 0.3016 0.0121

10 4276.30 0.2505 0.3044 0.2638 0.3172 0.0019

B. For 1985 – 2005 Period (119,813)

Size Decile

Total Assets

Book Long-term Debt

Book Total Debt

Market Long-term

Debt Market

Total Debt

% of Firms with Zero

Debt

% of Firms with Credit

Rating

1 3.36 0.0903 0.2087 0.0463 0.1003 0.2170 0.0000

2 10.67 0.1134 0.2110 0.0763 0.1433 0.1822 0.0004

3 23.72 0.1190 0.2023 0.0903 0.1548 0.1790 0.0006

4 46.41 0.1241 0.1934 0.1006 0.1586 0.1877 0.0022

5 84.14 0.1479 0.2078 0.1236 0.1751 0.1631 0.0128

6 154.28 0.1792 0.2323 0.1461 0.1920 0.1282 0.0551

7 293.57 0.2131 0.2628 0.1709 0.2133 0.0910 0.1533

8 611.28 0.2486 0.2963 0.1985 0.2382 0.0538 0.3279

9 1678.72 0.2479 0.2950 0.1962 0.2343 0.0379 0.5758

10 20778.29 0.2334 0.3005 0.1914 0.2458 0.0083 0.7800

Table IV. Credit Ratings, Firm Size, and Leverage Ratios

The data consist of firm-year observations for the period 19851-2005. Observations with missing values in any of the

reported variables are deleted. Credit ratings are Standard and Poor’s long-term credit ratings. Book /Market Long-

term/Total Debt is long-term/total debt over book/market value of total assets. The market value of assets equals total

assets minus total equity minus balance sheet deferred taxes and investment tax credit plus the market value of common

equity plus preferred stock liquidating value. Dividend is cash dividend divided by total assets. N is the number of

observations.

Credit Ratings

N Total

Assets

Book Long-term

Debt Book Total

Debt

Market Long-term

Debt Market

Total Debt Dividend

Before 1985 50844 4.4917 0.2668 0.1996 0.1953 0.2592 0.0142

0 (Unrated) 80476 4.0763 0.2195 0.1452 0.1150 0.1714 0.0081

1 (Below B) 610 6.2307 0.4756 0.3422 0.2983 0.4147 0.0022

2 (B) 3560 6.2826 0.4883 0.4413 0.3648 0.4064 0.0035

3 (BB) 4510 7.0817 0.4009 0.3635 0.2957 0.3277 0.0058

4 (BBB) 5393 8.0320 0.3133 0.2677 0.2182 0.2569 0.0135

5 (A) 4799 8.4704 0.2784 0.2122 0.1597 0.2113 0.0219

6 (AA) 1611 8.8645 0.2250 0.1608 0.1175 0.1609 0.0293

7 (A) 359 9.9890 0.1788 0.1017 0.0632 0.1084 0.0371

Table V. Firm Size Deciles, Cash Holdings, Retained Earnings, Dividend and External Financing Activities

The data consist of firm-year observations for the period 1971-2005. Observations with missing values in any of the

reported variables are deleted. Size deciles are based on total assets. All the variables are reported as a proportion of total

assets.

A. All firm-year observations (173,515)

Size Decile Cash and

Equivalents Retained Earnings

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend

1 0.4141 -3.8807 0.0023 -0.0004 0.2527 0.0077

2 0.4012 -0.8725 0.0024 0.0027 0.1164 0.0068

3 0.3989 -0.4103 0.0007 0.0025 0.0852 0.0078

4 0.3958 -0.1390 0.0013 0.0024 0.0777 0.0083

5 0.3725 0.0244 0.0044 0.0059 0.0604 0.0093

6 0.3475 0.0961 0.0103 0.0113 0.0453 0.0097

7 0.3157 0.1656 0.0174 0.0183 0.0273 0.0117

8 0.2784 0.1940 0.0219 0.0229 0.0158 0.0136

9 0.2469 0.1995 0.0219 0.0227 0.0082 0.0170

10 0.2195 0.2102 0.0163 0.0172 0.0017 0.0193

B. Non-IPO firm-year observations (154,156)

Size Decile Cash and

Equivalents Retained Earnings

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend

1 0.4033 -4.4562 0.0010 -0.0016 0.1744 0.0083

2 0.3945 -0.9800 0.0015 0.0019 0.0771 0.0069

3 0.3910 -0.4492 0.0007 0.0030 0.0495 0.0074

4 0.3797 -0.1444 0.0038 0.0056 0.0357 0.0073

5 0.3615 0.0281 0.0066 0.0084 0.0283 0.0082

6 0.3426 0.1029 0.0125 0.0140 0.0230 0.0092

7 0.3146 0.1742 0.0174 0.0183 0.0153 0.0111

8 0.2791 0.2003 0.0218 0.0228 0.0096 0.0132

9 0.2473 0.2047 0.0212 0.0219 0.0046 0.0164

10 0.2187 0.2120 0.0160 0.0168 0.0004 0.0193

C. Non-IPO firm-year observations within 1st and 99th percentiles of net new equity issue (151,058)

D. Non-IPO firm-year observations with zero-debt firms excluded (123,667)

Size Decile

Cash and Equivalents

Retained Earnings

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend

1 0.3976 -3.4280 0.0025 0.0017 0.0743 0.0086

2 0.3880 -0.8900 0.0019 0.0027 0.0541 0.0067

3 0.3870 -0.4281 0.0010 0.0040 0.0432 0.0073

4 0.3776 -0.1393 0.0037 0.0057 0.0346 0.0072

5 0.3599 0.0276 0.0064 0.0084 0.0289 0.0081

6 0.3411 0.1017 0.0119 0.0134 0.0248 0.0091

7 0.3140 0.1723 0.0168 0.0177 0.0177 0.0110

8 0.2784 0.1979 0.0214 0.0224 0.0122 0.0131

9 0.2469 0.2032 0.0206 0.0212 0.0073 0.0163

10 0.2181 0.2111 0.0156 0.0164 0.0021 0.0193

Size Decile Cash and

Equivalents Retained Earnings

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend

1 0.3558 -2.8477 0.0041 0.0063 0.0194 0.0028

2 0.3474 -0.6983 0.0050 0.0076 0.0164 0.0039

3 0.3444 -0.3126 0.0025 0.0068 0.0135 0.0054

4 0.3357 -0.0751 0.0074 0.0106 0.0117 0.0059

5 0.3225 0.0388 0.0097 0.0133 0.0106 0.0077

6 0.3127 0.1059 0.0156 0.0178 0.0107 0.0086

7 0.2940 0.1580 0.0197 0.0208 0.0115 0.0104

8 0.2676 0.1839 0.0231 0.0243 0.0116 0.0126

9 0.2398 0.1940 0.0214 0.0221 0.0102 0.0159

10 0.2162 0.1999 0.0158 0.0163 0.0065 0.0187

Table VI. Leverage, Dividend and Financing Activities across Firm Size Deciles, Negative/Positive Retained

Earnings

The data consist of firm-year observations for the period 1971-2005. Observations with missing values in any of the

reported variables are deleted. Size deciles are based on total assets. Firms are divided into positive (PosRE) and negative

(NegRE) retained earnings groups within each size decile. All the variables are reported as a proportion of total assets.

A. Cash Holdings, Dividend and Leverage

Size Decile Retained Earnings

Cash and Equivalents

Book Long-term Debt

Book Total Debt

Market Long-term Debt

Market Total Debt

1(NegRE) -5.2296 0.4144 0.1014 0.2276 0.0521 0.1098

1(PosRE) 0.3082 0.4132 0.0850 0.1447 0.0806 0.1370

2(NegRE) -1.7479 0.4062 0.1365 0.2508 0.0872 0.1619

2(PosRE) 0.3014 0.3944 0.1074 0.1748 0.1039 0.1684

3(NegRE) -1.2568 0.4267 0.1439 0.2463 0.1021 0.1770

3(PosRE) 0.2991 0.3748 0.1286 0.1952 0.1235 0.1877

4(NegRE) -0.8691 0.4397 0.1518 0.2370 0.1162 0.1832

4(PosRE) 0.2892 0.3688 0.1412 0.2051 0.1374 0.1998

5(NegRE) -0.6213 0.4221 0.1872 0.2702 0.1468 0.2152

5(PosRE) 0.2934 0.3510 0.1558 0.2111 0.1488 0.2023

6(NegRE) -0.5084 0.3784 0.2442 0.3198 0.1915 0.2548

6(PosRE) 0.2899 0.3371 0.1745 0.2264 0.1612 0.2109

7(NegRE) -0.4025 0.3146 0.3214 0.3939 0.2471 0.3074

7(PosRE) 0.2968 0.3159 0.1944 0.2437 0.1752 0.2213

8(NegRE) -0.3103 0.2600 0.3723 0.4357 0.2898 0.3442

8(PosRE) 0.2903 0.2823 0.2177 0.2656 0.1926 0.2354

9(NegRE) -0.3077 0.2327 0.3787 0.4394 0.2920 0.3434

9(PosRE) 0.2747 0.2492 0.2274 0.2748 0.2002 0.2415

10(NegRE) -0.1789 0.1896 0.3590 0.4179 0.2878 0.3378

10(PosRE) 0.2459 0.2226 0.2271 0.2905 0.2067 0.2612

B. External Financing Activities

Size Decile Retained Earnings

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend Number of

Observations

1(NegRE) -5.2296 0.0029 0.0008 0.3227 0.0039 12324 1(PosRE) 0.3082 0.0004 -0.0041 0.0348 0.0195 3989 2(NegRE) -1.7479 0.0027 0.0038 0.1766 0.0051 9318 2(PosRE) 0.3014 0.0020 0.0012 0.0353 0.0091 6891 3(NegRE) -1.2568 -0.0039 -0.0008 0.1446 0.0065 7426 3(PosRE) 0.2991 0.0045 0.0052 0.0348 0.0089 8575 4(NegRE) -0.8691 -0.0051 -0.0045 0.1465 0.0043 6013 4(PosRE) 0.2892 0.0050 0.0065 0.0370 0.0106 9764 5(NegRE) -0.6213 -0.0049 -0.0033 0.1255 0.0053 4744 5(PosRE) 0.2934 0.0083 0.0098 0.0330 0.0111 10931 6(NegRE) -0.5084 0.0039 0.0029 0.1051 0.0039 3937 6(PosRE) 0.2899 0.0124 0.0141 0.0259 0.0115 11657 7(NegRE) -0.4025 0.0160 0.0168 0.0706 0.0071 3059 7(PosRE) 0.2968 0.0177 0.0186 0.0170 0.0127 12270 8(NegRE) -0.3103 0.0196 0.0185 0.0483 0.0087 2665 8(PosRE) 0.2903 0.0224 0.0239 0.0092 0.0146 12551 9(NegRE) -0.3077 0.0356 0.0344 0.0310 0.0105 2102 9(PosRE) 0.2747 0.0197 0.0209 0.0047 0.0180 12897

10(NegRE) -0.1789 0.0209 0.0172 0.0165 0.0097 1397 10(PosRE) 0.2459 0.0159 0.0172 0.0003 0.0202 13324

Total 155834

Table VII. Retained Earnings Deciles, Firm Size, Leverage Ratios, Cash Holdings, Dividend and External

Financing Activities

The data consist of 172,765 firm-year observations for the period 1971-2005. Observations with missing values in any of

the reported variables are deleted. Retained earnings represent retained earnings divided by total assets. Book /Market

Long-term/Total Debt is long-term/total debt over book/market value of total assets. The market value of assets equals

total assets minus total equity minus balance sheet deferred taxes and investment tax credit plus the market value of

common equity plus preferred stock liquidating value. All the variables are reported as a proportion of total assets except

for Total Assets.

A. Firm Size and Leverage Ratios across Retained Earnings Deciles

Retained Earnings

Decile

Retained Earnings

Total Assets

Book Long-term Debt

Book Total Debt

Market Long-term

Debt Market

Total Debt

1 -5.1484 35.03 0.1545 0.2788 0.0956 0.1606

2 -0.8008 209.05 0.1912 0.2947 0.1506 0.2271

3 -0.2533 470.45 0.2281 0.3173 0.1930 0.2690

4 -0.0299 1194.38 0.2429 0.3221 0.2161 0.2882

5 0.0797 2968.16 0.2322 0.3053 0.2126 0.2809

6 0.1532 4977.87 0.2140 0.2786 0.1952 0.2549

7 0.2239 2727.63 0.1917 0.2464 0.1733 0.2237

8 0.3058 2137.97 0.1649 0.2117 0.1472 0.1900

9 0.4152 2052.23 0.1231 0.1617 0.1041 0.1378

10 0.6316 1242.15 0.0606 0.0841 0.0470 0.0656

B. Cash Holdings, financing Activities and Dividend Payouts across Retained Earnings Deciles

Retained Earnings

Decile Cash and

Equivalents

Net Long-term Debt

Issue Net Total

Debt Issue Net New

Equity Issue Dividend

1 0.4114 0.0004 -0.0028 0.2742 0.0033

2 0.3856 0.0067 0.0077 0.1427 0.0041

3 0.3517 0.0129 0.0156 0.0981 0.0057

4 0.3255 0.0207 0.0225 0.0680 0.0078

5 0.3075 0.0184 0.0204 0.0510 0.0094

6 0.3069 0.0186 0.0197 0.0367 0.0097

7 0.3089 0.0120 0.0128 0.0240 0.0104

8 0.3150 0.0084 0.0092 0.0122 0.0119

9 0.3271 0.0027 0.0026 0.0014 0.0163

10 0.3715 -0.0020 -0.0024 -0.0155 0.0272

Table VIII

OLS Estimation Results for Panel Regressions on Determinants of Leverage Ratio

The sample consists of 132,770 (92,172) firm-year observations with relevant Compustat data from 1971 to 2005 (1985 to

2005). The dependent variable is the total/long-term debt (TD/LD) divided by book/market value of assets (BA/MA). The

independent variables are as follows: dummy variable equal to one if the firm has negative retained earnings and zero

otherwise (NegRet); dummy variable equal to one if the firm has zero debt and zero otherwise (Zero); dummy variable

equal to one for IPO year and zero otherwise (IPO); cash and equivalents divided by total assets (Cash); industry median

debt ratio (Med); marginal tax rate equal to the statutory tax rate if the firm reports no net operating loss carryforwards

with positive pretax return and zero otherwise (Tax); operating Income divided by total assets (OI); market-to-book ratio

of assets (MB); log of book value of total assets (LnA); depreciation and amortization divided by total assets (DEP); fixed

assets divided by total assets (FA); research and development expenditures divided by total assets (RND); a dummy

variable for missing values in RND (D_RND); and common stock dividends divided by total assets (DIV). T-statistics are

in the parentheses.

A. All firms

TD / BA

TD /MA LD /BA LD / MA

Independent Variable

Constant 0.2878 0.5224 0.2149 0.4208 0.1384 0.4257 0.1034 0.3450

(120.69) (109.11) 97.45 102.17 66.89 102.15 56.27 98.58

RE.+Re -0.2850 -0.2163 -0.2445 -0.1742 -0.2366 -0.1745 -0.1962 -0.1377

(-108.89) (-65.95) -98.49 -60.86 -100.01 -60 -93.24 -56.32

RE.D-Re 0.0113 0.0103 0.0024 0.0006 0.0008 -0.0001 -0.0038 -0.0048

(17.72) (12.56) 3.9 0.89 1.41 -0.2 -7.51 -7.88

DNo -0.2305 -0.2136 -0.2895 -0.2477

(-59.74) -63.56 -84.69 -86.2

Rating -0.0445 -0.0496 -0.0592 -0.0557

(-46.05) -58.82 -69.11 -77.28

Cash -0.1958 -0.1838 -0.1760 -0.1604 -0.1331 -0.1220 -0.1219 -0.1123

(-72.73) (-58.35) -68.81 -58.38 -54.89 -43.84 -56.57 -48.03

LnA 0.0032 -0.0013 0.0026 0.0035 0.0132 0.0097 0.0104 0.0095

(14.94) (-3.79) 12.31 11.91 67.09 32.83 59.87 38.5

Div -0.0110 0.0271 -0.0740 -0.0432 -0.0317 0.0141 -0.0806 -0.0343

(-1.02) (1.95) -7.25 -3.58 -3.25 1.14 -9.31 -3.33

MB -0.0010 -0.0005 -0.0080 -0.0061 -0.0010 -0.0004 -0.0045 -0.0034

(-7.59) (-3.01) -62.75 -46.79 -7.83 -3.36 -41.29 -30.65

RND -0.0512 -0.0423 -0.0520 -0.0437 -0.0117 -0.0079 -0.0225 -0.0193

(-16.27) (-12.5) -17.42 -14.8 -4.12 -2.63 -8.93 -7.63

D0RD 0.0174 0.0199 0.0235 0.0259 0.0127 0.0144 0.0113 0.0151

(18.47) (16.58) 26.05 24.54 14.86 13.4 14.97 16.79

OI 0.0143 0.0140 -0.0155 -0.0136 0.0060 0.0023 -0.0175 -0.0185

(7.42) (5.88) -8.43 -6.51 3.42 1.07 -11.33 -10.39

MOI 0.1546 0.0006 0.3373 0.0397 0.0850 0.0024 0.1059 0.0044

(13.6) (0.04) 31.56 3.08 8.1 0.18 11.44 0.4

Zero -0.1676 -0.1679 -0.1200 -0.1101 -0.0980 -0.0973 -0.0664 -0.0614

(-109.61) (-93.36) -82.82 -70.27 -71.01 -61.04 -54.07 -45.85

IPO -0.0171 -0.0200 -0.0291 -0.0340 -0.0141 -0.0146 -0.0216 -0.0232

(-12.15) (-10.61) -21.74 -20.71 -11.06 -8.75 -19.06 -16.55

FA 0.0079 0.0207 0.0387 0.0532 0.0766 0.0802 0.0671 0.0800

(3.17) (6.65) 16.3 19.55 32.82 28.24 32.48 33.42

AZ -0.0085 -0.0077 -0.0013 -0.0004 -0.0009 -0.0002 0.0028 0.0034

(-18.92) (-13.28) -3.08 -0.71 -2.31 -0.42 7.77 7.73

Depr -0.0349 -0.0323 -0.0180 -0.0487 -0.0113 -0.0380 -0.0015 -0.0434

(-12.91) (-5.05) -7.02 -8.72 -4.64 -6.69 -0.67 -9.09

Tax -0.0104 -0.0167 0.0300 -0.0304 0.0218 0.0225 0.0215 0.0006

(-3.98) (-4.36) 12.14 -9.11 9.24 6.63 10.24 0.2

Med 0.3703 0.3279 0.3612 0.3044 0.3132 0.2540 0.4610 0.3372

(71.48) (50.94) 71.21 50.25 58.44 38.33 102.13 54.35

Adjusted-R2 0.4066 0.4101 0.3978 0.4155 0.3635 0.3905 0.4086 0.4178

B. Small versus Large Firms (1971-2005)

TD / BA

TD /MA LD /BA LD / MA

Independent Variable

Small Firms

Large Firms

Small Firms

Large Firms

Small Firms

Large Firms

Small Firms

Large Firms

Constant 0.2623 0.4341 0.1496 0.4454 0.0831 0.3736 0.0375 0.3418

77.06 94.77 50.23 102.56 30.75 86.96 16.22 88.48

RE.D+Re -0.2436 -0.3201 -0.1829 -0.2745 -0.1770 -0.2965 -0.1328 -0.2414

-61.46 -89.81 -51.27 -79.11 -53.62 -85.42 -46.9 -77.04

RE.D-Re 0.0049 0.0181 -0.0054 0.0317 -0.0045 0.0086 -0.0083 0.0182

5.71 11.52 -7.02 20.66 -6.34 5.62 -13.68 13.19

Cash -0.1807 -0.2084 -0.1662 -0.1919 -0.0997 -0.2010 -0.0947 -0.1794

-51.85 -45.77 -52.74 -43.25 -34.41 -45.35 -38.05 -44.94

LnA 0.0018 -0.0070 0.0136 -0.0131 0.0160 -0.0055 0.0193 -0.0077

3.13 -17.25 26.49 -33.34 33.62 -13.91 47.32 -21.7

Div 0.0375 -0.2229 -0.0021 -0.2808 0.0306 -0.2914 -0.0022 -0.3517

2.95 -9.17 -0.19 -11.87 2.9 -12.31 -0.24 -16.44

MB -0.0004 -0.0027 -0.0054 -0.0170 -0.0002 -0.0015 -0.0024 -0.0122

-2.82 -6.75 -38.59 -44.52 -1.69 -3.86 -21.56 -35.24

RND -0.0371 -0.3165 -0.0370 -0.3501 -0.0063 -0.2219 -0.0152 -0.2205

-10.64 -20.5 -11.77 -23.32 -2.16 -14.78 -6.11 -16.35

D0RD 0.0226 -0.0013 0.0290 -0.0002 0.0066 0.0039 0.0078 0.0001

16.06 -1.04 22.83 -0.2 5.61 3.11 7.74 0.06

OI 0.0001 0.0704 -0.0267 -0.1737 -0.0079 0.1073 -0.0241 -0.0798

0.03 8.71 -12.19 -22.04 -3.92 13.63 -13.86 -11.23

MOI 0.1961 0.0647 0.3773 0.2628 0.1403 -0.0365 0.1239 0.0697

12.23 4.03 26.49 16.85 10.21 -2.3 10.59 4.9

Zero -0.1748 -0.1453 -0.1283 -0.0932 -0.0961 -0.1091 -0.0690 -0.0626

-90.39 -54.43 -73.79 -35.88 -59.72 -41.99 -49.98 -26.69

IPO -0.0185 -0.0171 -0.0294 -0.0264 -0.0140 -0.0176 -0.0203 -0.0237

-9.87 -7.87 -17.45 -12.52 -8.99 -8.36 -15.18 -12.45

FA 0.0413 -0.0268 0.0474 0.0497 0.1249 0.0191 0.0951 0.0477

11.15 -7.73 14.31 14.48 39.66 5.42 35.6 14.84

AZ -0.0038 -0.0207 0.0040 -0.0147 0.0029 -0.0134 0.0058 -0.0075

-6.32 -30.64 7.26 -22.32 5.68 -20.3 13.42 -12.7

Depr -0.0181 -0.1560 0.0070 -0.2867 0.0028 -0.1466 0.0130 -0.1717

-5.74 -9.07 2.47 -17.01 1.06 -8.73 5.78 -11.23

Tax -0.0243 -0.0135 0.0181 0.0205 0.0269 -0.0118 0.0287 -0.0054

-5.86 -4.16 4.88 6.48 7.79 -3.71 9.64 -1.9

Med 0.3151 0.3819 0.3087 0.2978 0.2385 0.3105 0.3985 0.3992

40.7 55.09 42.07 43.19 31.33 40.97 61.21 63.44

Adjusted-R2 0.3629 0.4652 0.3584 0.4857 0.2779 0.4187 0.3329 0.4796

C. Rated versus Non-rated Firms (1971-2005)

TD / BA

TD /MA LD /BA LD / MA

Independent Variable

Rated Firms

Non-Rated Firms

Rated Firms

Non-Rated Firms

Rated Firms

Non-Rated Firms

Rated Firms

Non-Rated Firms

Constant 0.6679 0.2758 0.6138 0.1934 0.6435 0.1183 0.5617 0.0833

75.07 91.07 76.41 76.24 73.77 46.91 73.41 40.1

RE.D+Re -0.2868 -0.2233 -0.2583 -0.1751 -0.2998 -0.1808 -0.2536 -0.1385

-38.61 -62.81 -37.57 -57.47 -39.92 -58.77 -38.37 -54.61

RE.D-Re 0.0094 0.0065 0.0482 -0.0030 0.0074 -0.0029 0.0372 -0.0069

2.37 7.65 13.19 -4.08 1.85 -3.95 10.58 -11.33

Cash -0.1835 -0.1791 -0.2262 -0.1545 -0.1908 -0.1130 -0.2205 -0.1038

-18.47 -53.98 -24.66 -54.22 -19.01 -39.49 -25.02 -43.99

LnA -0.0293 0.0003 -0.0256 0.0038 -0.0313 0.0122 -0.0260 0.0110

-37.44 0.77 -35.24 12.83 -39.57 41.17 -37.31 44.91

Div -0.0689 0.0126 -0.1861 -0.0454 -0.2246 0.0130 -0.2519 -0.0302

-2.04 0.91 -5.95 -3.8 -6.57 1.07 -8.37 -3.03

MB 0.0008 -0.0004 -0.0119 -0.0055 0.0013 -0.0004 -0.0098 -0.0029

1.36 -2.74 -21.64 -42.01 2.09 -3.24 -18.52 -26.7

RND -0.3364 -0.0379 -0.3399 -0.0364 -0.2904 -0.0065 -0.2471 -0.0159

-10.28 -11.00 -11.25 -12.32 -8.77 -2.2 -8.51 -6.47

D0RD -0.0056 0.0242 0.0005 0.0291 0.0002 0.0145 0.0017 0.0153

-2.25 17.94 0.22 25.14 0.07 12.42 0.75 15.86

OI 0.1837 0.0049 -0.2164 -0.0200 0.1873 -0.0047 -0.1350 -0.0218

10.73 2.02 -13.64 -9.56 10.83 -2.24 -8.84 -12.54

MOI -0.0531 -0.0185 0.0622 0.0221 -0.0560 -0.0205 0.0233 -0.0102

-1.65 -1.15 2.08 1.61 -1.69 -1.46 0.81 -0.89

Zero -0.3054 -0.1644 -0.1881 -0.1088 -0.2602 -0.0951 -0.1566 -0.0611

-21.3 -90.17 -14.18 -69.78 -17.94 -60.39 -12.27 -47.1

IPO 0.0206 -0.0227 -0.0152 -0.0340 0.0235 -0.0172 -0.0107 -0.0232

3.59 -11.42 -2.85 -19.96 4.04 -10.01 -2.09 -16.39

FA -0.0818 0.0391 -0.0115 0.0621 -0.0561 0.1003 -0.0120 0.0904

-13.29 11.12 -1.96 20.68 -8.69 32.18 -2.07 35.2

AZ -0.0329 -0.0051 -0.0195 0.0023 -0.0233 0.0017 -0.0121 0.0048

-21.13 -8.38 -13.55 4.34 -14.79 3.26 -8.69 11.16

Depr -0.0179 -0.0320 -0.0282 -0.0347 -0.0216 -0.0371 -0.0301 -0.0333

-0.59 -4.79 -0.99 -6.05 -0.7 -6.43 -1.1 -6.98

Tax -0.0188 -0.0313 -0.0286 -0.0337 -0.0077 0.0119 -0.0256 -0.0023

-2.71 -7.1 -4.47 -8.93 -1.1 3.12 -4.15 -0.73

Med 0.3139 0.3347 0.2270 0.3034 0.2629 0.2537 0.3000 0.3239

23.48 47.27 17.82 45.06 17.55 34.94 21.63 47.33 Adjusted-

R2 0.3884 0.3642 0.4516 0.3622 0.3658 0.2939 0.4342 0.3256