Financial Flexibility and Leverage Cycles: How Agile Firms Adjust Capital Structure and Reallocate Strategic Resources

Abstract

This dissertation examines how publicly listed U.S. firms manage capital structure and use financial flexibility in corporate decision-making. Using annual Compustat data for U.S. public industrial firms over the period 1990–2024, the dissertation consists of two related essays. The first essay examines whether firms adjust leverage toward estimated target capital structure and whether the speed of adjustment differs across leverage states. Target leverage is estimated from lagged firm characteristics within a partial-adjustment framework. The results show that firms move their leverage toward estimated targets and close a substantial share of the target gap within one year. Additional analyses indicate that adjustment is asymmetric, with over-levered firms adjusting faster than under-levered firms. These findings remain robust to a dynamic adjustment specification, alternative leverage definitions, a debt-to-assets benchmark, and excluding firms close to target leverage.

The second essay examines whether financial flexibility is associated with subsequent corporate investment. Financial flexibility is measured using leverage burden, interest-servicing capacity, and cash-flow stability. The results show that firms with greater financial flexibility invest more in the following year. Additional analyses indicate that this association is concentrated mainly in the first two years and is stronger among firms that appear more financially constrained. The positive association remains when investment is measured more broadly and when alternative financial flexibility measures are used. The results also show that the association remains after 2008, although it becomes weaker in the later period. Overall, the dissertation provides evidence that average adjustment speeds and investment responses mask important firm-level heterogeneity. The findings suggest that leverage position and financial flexibility are important for understanding how firms adjust capital structure and reallocate resources over time.