We document that a firm's inflexibility to adjust its productive scale reduces its financial leverage, based on a theory-grounded inflexibility measure. Higher default risk and lower value of tax shields associated with inflexibility are two potential channels. Further evidence shows that contraction inflexibility plays a more critical role in determining financial leverage than expansion inflexibility. Moreover, the substitution effect between financial and operating leverage is weaker among flexible firms. In addition, inflexible firms increase financial leverage more than flexible firms following a positive credit supply shock. Our results suggest that inflexibility shapes corporate financial policies.
L. Gu, D. Hackbarth, Tong Li
SSRN Electronic Journal