Determinants of corporate leverage adjustments: A cross-country analysis

Capital structure literature suggests that firms are very likely to consider target leverage ratios when they issue new capital (Graham & Harvey, 2001). Albeit the dynamic trade-off theory predicts that firms have incentives to move toward target debt ratios by reducing any deviation from those targets (Frank & Goyal, 2009), due to substantial financing frictions, i.e. issuance costs or intermediation costs, firms may decide to temporarily deviate from their target levels. A recent strand of research has investigated significant factors that affect such adjustment costs or firms’ leverage SOA. This thesis consists of three essays that investigate crucial determinants of corporate leverage adjustments: equity liquidity, corporate sustainability performance (CSP), and employment protection laws (EPL). Chapter 1 examines the impact of liquidity on the speed of adjustment (SOA) of corporate leverage at the individual company level. Using a sample of UK firms and data from 35 countries, respectively, over the period from 1996 to 2016, the chapter finds that high-liquidity firms have a significantly faster SOA than less liquid firms. This result survives a series of robustness checks and holds after addressing the endogeneity concern using exogenous shocks and additional control variables. Further analyses imply that the positive effect of liquidity on the SOA exists only for over-levered firms, and this impact is moderated in countries with bankruptcy codes. In the cross-section, the chapter suggests that the positive relationship between liquidity and SOA is more pronounced for firms whose current position is relatively close to its target leverage ratio and whose target ratio is relatively stable. The chapter further shows that the positive equity liquidity-SOA association is less (more) pronounced for firms in strong (weak) institutional environments. The results provide new insights into the role of liquidity in firms’ capital structure decisions and the determinants of capital structure dynamics. Chapter 2 investigates the impact of corporate sustainability performance (CSP) on the speed at which firms adjust their leverage to the target ratios. Using a large sample of 31 countries from 2002 to 2018 with two proxies of CSP, the chapter suggests that firms that invest more in CSP move faster toward their target leverage. In exploring the potential underlying economic mechanisms through which CSP affects leverage adjustments, the chapter shows that superior CSP plays an important role in easing information asymmetry, enhancing stakeholder engagements, pushing up stock prices in the stock market, and improving competitive advantages in the product market of firms. In further analyses, the positive association between CSP and leverage SOA is shown to be less pronounced in countries with high-quality institutions. The results remain statistically and quantitatively unchanged from numerous robustness tests and IV estimates. Overall, this chapter enlightens the crucial role of CSP in shaping the firm’s decisions on dynamic capital structure and provides implications for strategic planning of firms on the optimal choices of CSP investments. Finally, chapter 3 highlights the impact of employment protection laws (EPLs) on the speed of corporate leverage adjustments. By exploiting within-country changes in EPLs across 19 OECD countries, the chapter suggests that firms operating in countries with more stringent EPLs have significantly low leverage adjustment speeds. This association is consistent with the view that stringent EPLs raise firms’ costs of adjustment on target leverage. The result survives several tests addressing the endogeneity concern by instrument variable approach, Rajan and Zingales (1998)’s method, and additional control variables and is robust to a battery of robustness checks. The chapter further demonstrates that the response of leverage adjustment to changes in EPLs is more pronounced in countries with effective legal enforcement. Generally, results of the chapter are consistent with the dynamic trade-off theory of capital structure