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The Information Effects of Financial Leverage: A Dynamic Approach
Shenoy, Catherine Anne
Shenoy, Catherine Anne
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Abstract
This dissertation is about capital structure theory under asymmetric information. In particular, I examine the relationship between cash flow and financial leverage over time. This relationship is important because signalling theory and pecking order behavior in financing seem to have opposite implications for the relationship. Further, two sets of empirical results-leverage-changing event studies and cross-sectional regression studies-also have seemingly conflicting results. I show that the apparent contradictions can be resolved be considering the dynamic aspects of the cash flow/leverage relationship.
Both signalling theory and the pecking order behavior describe the relationship between cash flow and leverage. In signalling theory, cash flow and leverage must have a monotonic relationship, and most theories predict that this relationship is positive. The relationship between cash flow and financial leverage is also important in a pecking order of financing. Pecking order behavior suggests that holding investment constant, higher cash flows are associated with lower leverage. Cross-sectional leverage studies generally support the pecking order view, while leverage-changing event studies generally support the signalling view.
I propose a model that takes into account both the simultaneous and intertemporal relationship between cash flow and leverage. Because cash flow and leverage are determined simultaneously, cross-sectional studies that ignore the simultaneity may be biased and inconsistent Lagged cash flow is also a determinant of leverage. A pecking order suggests that firms with more slack will use less leverage, thus excess cash flow in the past may affect current decisions about how much debt to issue. Similarly, cash flow is also affected by current and lagged values of leverage. Under the signalling hypothesis, lagged values of leverage provide information about current cash flow.
Risk is also an important element in the relationship between cash flow and leverage. It is simultaneously determined with cash flow and leverage. Thus an appropriate model to capture the simultaneous nature of risk, cash flow, and leverage is a system of pooled time series equations. These results show that lagged values of leverage tend to have more significant positive coefficients, but the contemporaneous coefficients are negative. The across-time results support the signalling hypothesis, since a signal should give information about future cash flows. The contemporaneous lag coefficients are negative. This supports the notion that pecking order behavior is a description of contemporaneous behavior.
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Date
1991-06-30
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University of Kansas