The effects of uncertainty on the leverage of nonfinancial firms.

I. INTRODUCTION

The determinants of capital structure have always attracted considerable attention in the literature. In their seminal work, Modigliani and Miller (1958) derive the theoretical result that under the assumption of perfect capital markets, financial and real decisions are separable so that the firm's leverage has no effect on the market value of the firm, nor on its capital investment plans. However, recent empirical research provides contrary evidence. For instance, a vast number of studies show a positive relationship between liquid asset holdings and firms' investment decisions. (1) Other studies show that firm leverage depends on firm-specific characteristics such as cash holdings, total assets, and the investment-to-capital ratio. (2) Furthermore, empirical evidence on the interaction between macroeconomic uncertainty and capital structure indicators is rather scarce. As an exception, Baum et al. (2006) find a negative relationship between macroeconomic uncertainty and the cross-sectional dispersion of cash-to-asset ratios for U.S. nonfinancial firms. Hence, their study supports the view that macroeconomic uncertainty is an important factor in firms' decision making. By furthering this idea, we intend to contribute to the literature on corporate debt by analyzing the impact of macroeconomic and idiosyncratic uncertainty on the optimal level of nonfinancial firms' leverage.

We formulate a dynamic, stochastic, partial equilibrium model of a representative firm's value optimization problem. The model is based on an empirically testable hypothesis regarding the association between the optimal level of debt and uncertainty arising from macroeconomic or idiosyncratic sources. The model predicts that an increase in either type of uncertainty leads to a decrease in leverage.

To test the model's predictions, we apply the System Generalized Method of Moments (System-GMM) estimator (Blundell and Bond 1998) to a panel of U.S. nonfinancial firms obtained from the quarterly COMPUSTAT database over the period from 1993 to 2002. After some screening procedures, it includes more than 31,000 manufacturing firm-quarter observations, with about 950 firms per quarter. As the impact of uncertainty may differ across categories of firms, we also consider four sample splits. Our main findings can be summarized as follows. We find evidence of a negative association between the optimal level of debt and macroeconomic uncertainty as proxied by the conditional variance of the index of leading indicators. When the macroeconomic environment becomes more uncertain, companies behave more cautiously and borrow less, even when they might expect to face decreased revenues and potential cash flow shortages. Furthermore, idiosyncratic uncertainty also has a negative and significant effect on firms' use of leverage. These results are robust to the inclusion of macroeconomic factors summarized by the index of leading indicators.

These results provide useful insights into corporate capital structure decisions. Changes in macroeconomic uncertainty, partially influenced by monetary policy, will affect not only firms' leverage but also their costs of obtaining external finance and in turn their investment dynamics. Moreover, monetary policy will have an effect on the discount rates of investment projects. Therefore, our results suggest that the transmission mechanism of monetary policy is much more complicated than formulated in standard models that ignore the interaction of real and financial variables' first and second moments.

The remainder of the paper is structured as follows. Section II presents a simple value maximization model for a representative firm. Section III describes the data and discusses our results. Finally, Section IV concludes and gives suggestions for further research.

II. THE Q MODEL OF FIRM VALUE OPTIMIZATION