Financial Flexibility, Investment Ability, and Firm Value: Evidence from Firms with Spare Debt Capacity

Authors

  • Maria-Teresa Marchica,

    1. Maria-Teresa Marchica is a Lecturer in Finance at the Manchester Business School, University of Manchester, Manchester, England M13 9PL, UK.
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  • Roberto Mura

    1. Roberto Mura is a Lecturer in Finance at the Manchester Business School, University of Manchester, Manchester, England M13 9PL, UK.
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  • We thank Bill Christie (editor) and the anonymous referee whose comments have significantly helped to improve the paper. We are indebted to Michael Brennan, Harry and Linda DeAngelo, Marie Dutordoir, Mara Faccio, Annalisa Ferrando, Andrea Gamba, Ian Garrett, Marc Goergen, Alessandra Guariglia, John Hutton, Evangelos Kharalambakis, Meziane Lasfer, WeiMin Liu, Kasper Nielsen, Aydin Ozkan, Ser-Huang Poon, Norman Strong, Alex Taylor, Alex Triantis, and Sergey Tsyplakov for helpful discussions. We also thank all the participants in the FIRS 2008, FMA USA 2008, FMA Europe 2008, EFA USA 2007, FMA Europe 2007, EFMA 2006, and FMA USA 2006 “Top Ten Percent” Special Session, and PFN 2006 meetings for their insightful comments. We are also grateful to the participants in the seminar series at European Central Bank, Cass Business School, Manchester Business School, the Nottingham Department of Economics, Sheffield Management School, and the University of Verona for their useful suggestions. Kind help from David Roodman of the Center for Global Development, Roger Walsh of Bureau Van Dijk, Derek Rouse of Hemscott Plc Support Team and Francesco Cerlienco of Reuters is also acknowledged. We are also grateful to Wendy Jennings, Pam Losefsky, and Alison Walters for editorial help. The usual disclaimer applies.

Abstract

We document, for the first time, that a conservative leverage policy directed at maintaining financial flexibility can enhance investment ability. Our analysis reveals that following a period of low leverage, firms make larger capital expenditures and increase abnormal investment. We find that these new investments are financed through new issues of debt. The impact of financial flexibility is both statistically significant and economically sizable. Further, long-run performance tests reveal that financially flexible firms not only invest more but also invest better. Our results are consistent with the view that financial flexibility in the form of untapped reserves of borrowing power is a crucial missing link in capital structure theory.

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