Receptivity of capital structure with financial flexibility: A study on manufacturing firms

Abstract The purpose of this paper is to empirically investigate the static capital structure decisions' dynamic responses due to shocks and its relative sensitivity in the presence of financial flexibility. To capture this, we use Panel Corrected Standard Error (PCSE) models and Panel Vector Autoregression (Panel‐VAR) models on the sample of 2,094 listed Indian Manufacturing firms from 2009 to 2019. The empirical findings demonstrate substantial difference in the dynamic responses of capital structure under the conditions of shocks given to its key determinants, with and without financial flexibility. Debt ratio of financially flexible firms reacts positively to asset tangibility and size whereas it reacts negatively to growth opportunity, non‐debt tax shield and profitability. These findings may assist firm managers and policy makers in gauging the limitations associated with leveraging their debt structure on the virtue of being financially flexible.