Inflexibility and Leverage

Abstract

We examine whether a firm's infl exibility (i.e., inability to adjust its scale in response to profitability shocks) infl uences its financial policy. Based on a firm's historical range of operating costs-to-sales ratio, scaled by the volatility of its sales growth, we find robust evidence that in flexible firms adopt a lower level of financial leverage compared with exible firms. This effect is much more pronounced among value firms where the in flexibility to scale down during economic downturns is relatively more important. Following a positive credit supply shock induced by staggered state-level bank branching deregulation or the introduction of credit default swap (CDS), infl exible firms increase leverage more than flexible firms. These results suggest that operating fl exibility plays an important role in shaping corporate financial policies.