Capital Structure, Payout Policy, and Financial Flexibility

by Harry DeAngelo* Linda DeAngelo*

July 2006 Revised October 10, 2007

Abstract We combine elements of the pecking order and trade-off theories of capital structure to develop a more powerful and empirically descriptive theory in which firms have low long-run leverage targets, debt issuances are temporary deviations from target to meet unanticipated capital needs, firms rebalance to target with a lag despite zero adjustment costs, and mature firms pay substantial dividends to foster access to external equity while limiting internal funds to control agency costs and reduce corporate taxes. The theory generates new testable hypotheses and resolves the main capital structure puzzles including (i) why equity is not “last resort” financing, (ii) why profitable firms pay dividends and maintain low leverage despite the corporate tax benefits of debt, (iii) why firms fail to “lever up” after stock price increases, and (iv) why leverage rebalancing occurs with a lag despite trivial adjustment costs.

This work was supported by the Charles E. Cook/Community Bank and Kenneth King Stonier Chairs at the Marshall School of Business of the University of Southern California. We thank Eugene Fama, David Hirshleifer, Ronald Masulis, Jay Ritter, Berk Sensoy, René Stulz, Amir Sufi, and Mark Westerfield for helpful comments on an earlier draft. hdeangelo@marshall.usc.edu or ldeangelo@marshall.usc.edu

Capital Structure, Payout Policy, and Financial Flexibility 1. Introduction Financial flexibility is the single most important determinant of capital structure according to CFOs (see, e.g., Graham and Harvey (2001)), yet the only prominent theory to recognize its value --Myers and Majluf’s (1984) pecking order model --- has serious empirical shortcomings. In fact, Fama and French (2005) conclude that the pecking order is “dead” as a stand-alone theory of capital structure because of its inability to explain why