In a setting where firms can choose their capital structures, we derive the optimal compensation contract for employees who are averse to bearing their own human capital risk, while equity holders can diversify this risk away. In the absence of other frictions, the optimal contract implies that all firms will be unlevered, and instead will hold cash. In the presence of corporate taxes, the optimal contract implies optimal debt levels consistent with those observed, implying that the importance of human capital risk is comparable to that of taxes in the capital structure decision. Our model makes a number of predictions for the cross-sectional distribution of firm leverage. Consistent with existing empirical evidence, it implies the existence of persistent unexplained idiosyncratic differences in leverage across firms. It also predicts that, ceteris paribus, firms with more leverage should pay higher wages, an as yet unexplored empirical implication of the model. JEL classification: G14.

Abstract not found

We thank Nick Bloom and Steve Bond for providing the data used in the paper and seminar participants at the Bank of England, Bank of Spain and Royal Economic Society Annual Conference (Warwick) for comments. The usual disclaimer applies. The views expressed in this paper are those of the authors and should not be thought to represent those of the Bank of England or Bank of Spain. Copies of working papers may be obtained from Publications Group, Bank of England,

... financial policies. These "under-leveraged" firms carry substantially less debt than predicted by dominant theories of capital structure (Graham (2000) and Myers (1984)). This paper examines the phenomenon of financial conservatism by studying firms that adopt a persistent policy of low leverage. Our major findings are as follows. 1) Conservative firms follow a pecking order style financial policy. A high flow of funds and substantial cash balances allow them to fund the bulk of discretionary expenditures internally. 2) Financial conservatism is largely transitory. Seventy percent of low leverage firms drop their conservative financial policy; almost 50% do so within five years. 3) Conservative firms stockpile financial slack or debt capacity. Their "stockpiles" are utilized later to finance discretionary expenditures, particularly acquisitions and capital expenditures.. 4) Financial conservatism is not an industry-based phenomenon. Conservative firms do, however, have relatively high market-to-book and operate relatively frequently in industries thought to be sensitive to financial distress. 5) Conservative firms do not have low tax rates, high non-debt tax shields or face severe information asymmetries.

There are relatively few direct tests of the economic effects of asymmetric information because of the difficulty in identifying exogenous information measures. We propose a novel exogenous measure of information based on the quality of property tax assessments in different regions and apply this to the U.S. commercial real estate market. We find strong evidence that information considerations are significant. Market participants resolve information asymmetries by purchasing nearby properties, trading properties with long income histories, and avoiding transactions with informed professional brokers. The evidence that the choice of financing is used to address information concerns is mixed and weak. We thank Michael Arabe, John Edkins, and Peggy McNamara as well as COMPS.com for providing commercial real estate data. We are grateful to Stephen Cauley for his assistance and advice and have benefitted from the

This paper argues that the standard pecking order hypothesis is only a special case of the adverse selection argument about external financing. It only applies when there is no asymmetric information about risk so that there is no adverse selection cost of debt. As soon as outside investors are imperfectly informed about risk, debt, a concave claim, will be mispriced. Using a large unbalanced panel of publicly traded US firms, we present robust and economically significant evidence i) that there is a general adverse selection in which firms issue consistently more equity and less debt if risk matters more and ii) that the special case of the pecking order, i.e. no adverse selection cost of debt, works well when risk does not matter, irrespective of firms ’ age, size, market-to-book ratio, tangibility or the time period. We thank Heitor Almeida, Dan Bergstresser, Kobi Boudoukh, Alexander Ljungqvist, Eli Ofek, Daniel Wolfenzon, Jeff Wurgler and seminar participants at NYU for helpful comments.- 0-The pecking order theory of capital structure, one of the most influential theories of corporate leverage, has recently fallen on hard times. On the one hand, the theory has considerable intuitive appeal. Firms seeking outside finance naturally face an adverse

The notion that firms have a debt ratio target which is a primary determinant of financing behavior is influential in finance. Yet, how definitive is the evidence? We address this issue by generating samples where financing is unrelated to a firm’s current debt ratio or a target. We find that much of the available evidence in favor of target behavior based on leverage ratio changes can be reproduced for these samples. Taken together, our findings suggest that a number of existing tests of target behavior have no power to reject alternatives.

We argue that a firm’s aggregate risk is a key determinant of whether it manages its future liquidity needs through cash reserves or bank lines of credit. Banks create liquidity for firms by pooling their idiosyncratic risks. As a result, firms with high aggregate risk find it costly to get credit lines from banks, and opt for cash reserves in spite of higher opportunity costs and liquidity premium. We verify this hypothesis empirically by showing that firms with high asset beta have a higher ratio of cash reserves to lines of credit, controlling for other determinants of liquidity policy. The effect of aggregate risk on liquidity management is economically significant, and is robust to variation in the proxies for firms ’ exposure to aggregate risk, and availability of credit lines. This effectistrueatthe firm level as well as the industry level, and it is significantly stronger in times when aggregate risk is higher. The positive relation between a preference for cash and asset risk is particularly strong for firms that are more likely to be financially constrained (small, non-rated, low payout firms).

A number of prominent papers in the literature have estimated the speed of adjustment (SOA) of firms ’ leverage ratios with estimators not designed for applications in which the dependent variable is a ratio. This made them detect mean reversion, which they mistakenly considered as readjustment. We propose a non-parametric way to model leverage ratios under the NULL, and a method of reconciling incongruous estimates. Using the earlier estimators, the best joint estimate for the true SOA is zero or negative. There is evidence for some heterogeneity in SOAs across firms.

We examine whether market andoperating performance affect corporate financing behavior because they are relatedto target leverage. Our focus on firms that issue both debt andequity enhances our ability to draw inferences. Consistent with dynamic trade-off theories, dual issuers offset the deviation from the target resulting from accumulation of earnings and losses. Our results also imply that high market-to-book firms have low target debt ratios. On the other hand, consistent with market timing, high stock returns increase the probability of equity issuance but have no effect on target leverage.