On Capital Structure and the Liquidity of a Firm's Stock
38 Pages Posted: 6 Feb 2006
Date Written: March 7, 2006
Though prior capital structure literature suggests a causal relation between liquidity and leverage (i.e., liquidity affects leverage), we explore the notion that these variables are jointly determined. Consistent with the idea that debt forces managers to make better investment decisions, we find that as leverage increases, spreads decrease. Results from our empirical analysis further imply that as liquidity decreases, leverage increases, which is consistent with the notion that managers rely on debt financing when equity financing becomes relatively expensive. While controlling for the endogenous relationship between spreads and leverage greatly reduces the impact of spreads on leverage, results from our method suggest that a one standard deviation increase in spreads results in a 3% increase in leverage. Not only do our results add to the understanding of the complex relationship between capital structure and liquidity, they also shed light on the determinants of leverage and bid-ask spreads.
Keywords: Liquidity, leverage, capital structure, spreads
JEL Classification: G14, G30
Suggested Citation: Suggested Citation