Financial Flexibility, Investment Ability, and Firm Value: Evidence from Firms with Spare Debt Capacity

We document, for the first time, that a conservative leverage policy directed at maintaining financial flexibility can enhance investment ability. Our analysis reveals that following a period of low leverage, firms make larger capital expenditures and increase abnormal investment. We find that these new investments are financed through new issues of debt. The impact of financial flexibility is both statistically significant and economically sizable. Further, long‐run performance tests reveal that financially flexible firms not only invest more but also invest better. Our results are consistent with the view that financial flexibility in the form of untapped reserves of borrowing power is a crucial missing link in capital structure theory.