Abstract
Surprisingly little is known about the business cycle dynamics of leverage. The existing evidence documents that target leverage evolves pro-cyclically either for all firms or financially constrained ones. In contrast, we show that, on average, target leverage ratios evolve counter-cyclically once cyclicality is measured comprehensively, accounting for variation in explanatory variables and model parameters. These counter-cyclical dynamics are robust to different subsamples of firms, data samples, empirical models of leverage, and definitions of leverage. There is a fraction of 10–25% of firms with pro-cyclical dynamics whose characteristics are consistent with counter-cyclical dynamics for loss-given-default and probability of default.
1. Introduction
The recent financial crisis and the following sharp economic recession have sparked substantial interest in the link between macroeconomic conditions and firms’ financial structures. During recessions most of the main theoretical capital structure determinants experience significant shocks. For example, corporate cash flows drop for many firms and their effective corporate tax rates are reduced. This may give rise to demand variation of firms’ optimal capital structure over the business cycle. Maybe equally important, capital market conditions also covary with macroeconomic conditions generating supply effects on optimal capital structure.1 Moreover, demand and supply effects may be interacted by changing the link between corporate characteristics and optimal financial leverage. Documenting and understanding the relation between macroeconomic conditions and capital structure dynamics may therefore generate important insights about firms’ financing decisions more generally.
6. Conclusion Surprisingly little is known about the dynamics of leverage over the business cycle. Both theoretical predictions and empirical evidence are scarce, ambiguous, and strongly model-dependent. Importantly, the empirical literature so far has not analyzed the overall dynamics of (target) leverage; instead, it has only focused on the coefficients of recession dummies or macroeconomic variables in empirical models, which only capture the marginal effects.
