A company’s capital structure — its ratio of debt to the sum of debt and equity market value — is important for assessing the organization’s financial flexibility and ability to access capital in the future.

If the company has a high debt-to-equity ratio, for instance, it’s said to be highly leveraged and may have fewer opportunities to borrow funds to support innovation. The ratio also can influence investors’ decisions regarding the company.

Determining an optimal capital structure has been for decades a Holy Grail for practitioners and academics alike. Research documents that profitability, company size, and macroeconomic conditions are among the many factors that influence managers in making these decisions.

Surveys of CFOs in the United States and Europe, however, have ranked maintaining financial flexibility as the primary determinant in setting a company’s financing policy. It’s defined as the company’s ability to take advantage of new investment opportunities as they come along, or sustain ongoing projects, via borrowing.

If the company has already borrowed heavily, it has low debt capacity — i.e., it’s relatively unlikely to be able to secure significant funding in the future. Hence, it is not financially flexible and may not be able to fund new, profitable projects or cope with future temporary setbacks.

A new study by Prof. Costas Lambrinoudakis of Leeds University Business School, PhD student Konstantinos Gkionis of Queen Mary University of London, and myself sheds light for the first time on how the need for financial flexibility feeds into a firm’s financing policy.

The research tested a main prediction of the financial flexibility paradigm: that expectations about future company-specific investment shocks affect a company’s leverage and may be the main driver of managers’ capital structure decisions.

We used the market prices of equity options to extract the (risk-neutral) expectations of market participants for small and extreme movements in company stock prices. This information may also proxy managers’ expectations for small and large future investment shocks.

We used this information to test a financial flexibility hypothesis: that when a manager expects either a small or a large shock, she/he will decrease the company’s leverage in order to maintain the financial flexibility to be able to borrow in the future.

According to the hypothesis, that’s the case whether the expectation is for a good shock or a bad one. If the manager expects something good to happen in the future (good shock), she will borrow less now so she can borrow more in the future to take advantage of potential profitable investments. If she expects something bad to happen in the future (bad shock), she will borrow less now so she can increase leverage in the future to keep already undertaken investments running.

Our findings verified the hypothesis. Moreover, we found that expectations for both small and large investment shocks — as captured by expectations for small and big movements in company stock prices — are very important to managers in setting capital structures.

We found that managers set the current quarter’s leverage ratio by taking into account shocks expected to be realized over the next 12 months. This indicates that managers also take into account expectations for longer-horizon shocks — those expected to be realized at times beyond the period over which they will reset their leverage.

Therefore, managers are not myopic but rather take a longer-term view when setting current leverage.

Furthermore, our research shows that the impact of expectations for future investment shocks on leverage is stronger than standard determinants of leverage, such as profitability and size.

For instance, a one-standard-deviation increase in the expected volatility of a company’s stock returns over the next 12 months, which equals 13%, would decrease the leverage ratio by 4.2%.

That decrease is sizable, because it equals nearly 25% of the mean leverage ratio of companies in the study’s sample (quarterly data, 1996-2017, all companies belonging to any of the S&P LargeCap 500, S&P MidCap 400, and S&P SmallCap 600 indices for which accounting and equity option data are available).

A change of comparable magnitude in a company’s size or profitability would alter its leverage ratio just 1.1% and 2.2%, respectively. This indicates that the impact of expectations for future investment shocks on leverage is 3.8 and 1.9 times stronger than the impact of size and profitability, respectively.

The impact of expectations of investment shocks on leverage also differs across companies. The research showed that the aforementioned change in the expected volatility of a firm’s stock returns over 12 months would decrease the leverage ratio of small companies (mostly those with a market cap of $10 billion or lower) by 6.7%, whereas the leverage of large companies would decrease by only 2%.

Likewise, the leverage ratio of companies with and without a credit rating would decrease by 1.9% and 5.8%, respectively.

These findings indicate that the leverage of small and financially constrained companies is roughly three times more sensitive to expectations for shocks than that of big and financially unconstrained firms, as expected under the financial flexibility paradigm. This is because these firms have more difficulty in borrowing.

Therefore, in anticipating future shocks, their managers borrow even less today to preserve a greater debt capacity and set a lower leverage as a result.

We used options data from OptionMetrics to extract measures for proxy managers’ expectations about future shocks. The option prices provide insight into potential small and large movements in the underlying stock prices.

Equity options (i.e., options whose underlying asset is a stock, such as IBM options written on IBM stock) offer this insight, as they are forward-looking instruments: the payoff of the option is dependent on the price of the underlying asset in the future.

Therefore, the market prices of these options are determined by the expectations of risk-neutral investors about the future price of the underlying asset, and hence provide feedback on market expectations.

We also suggest, and previous research confirms, that managers comprise a substantial portion of the investors who hold and trade stocks and options for their own firms. Voluminous literature exists on how the informational content of market option prices can be used to address a number of questions in finance.

In sum, the study corroborates formally the results of previous surveys that company managers do care about what when happen in the future when setting the current firm’s financing policy. Managers try to set capital structures in a way that will optimize their organizations’ value.

We recommend that company managers use expectations extracted from the option market in their quantitative models to set capital strategy.

George Skiadopoulos is a professor at Queen Mary University of London and the University of Piraeus in Athens.

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