Abstract

Financial flexibility is a firm’s ability to deploy its financial resources to meet future financing needs. Flexibility-building firms’ financial decisions are geared toward building up financial flexibility — maintain low leverage by issuing equity in order to raise cash. As firms progress and start making investments, they utilize their financial resources — flexibility-utilizing firms increase debt and use reserved cash in order to exercise investment options. As more cash flows are generated and investment opportunities diminish, firms recharge their financial flexibility by repaying debt and increasing cash using internal funds. The findings have important implications for previously documented empirical regularities.

Identifying and financing investment opportunities are crucial to any successful corporation. Financial flexibility reflects a firm’s ability to deploy financial resources in response to future investment opportunities. Not surprisingly, corporate managers are most concerned about financial flexibility in their financial decisions.1 Yet, the empirical literature has not yet systematically explored the relation between the financial flexibility demand and corporate behavior. This study examines how the demand for financial flexibility affects firms’ financial decisions. A recent theoretical development provides a framework for understanding how a firm’s demand for financial flexibility drives financial decisions. Gamba and Triantis (2008) suggest that by managing their cash and capital structure policies, firms alleviate the impact of external financing costs on investments. Moreover, they find that the effect of financial flexibility on firm value is quite significant when constrained firms have high growth opportunities and low internal cash flows. Acharya, Almeida, and Campello (2007) also suggest that firms with low correlation between cash flows and investment opportunities have greater incentives to transfer resources into future states. DeAngelo et al. (2011) develop a model in which firms preserve the ability ex ante to access the capital market ex post in the event of unexpected cash flow shortfalls or investment opportunities.