The Effect of Economic Uncertainty and Investment Increase on the Financial Leverage Adjustment Speed

Abstract

One of the goals of firms is to optimize their capital structure. Due to transaction costs, the actual capital structure is always deviated from the optimal and cannot be immediately adjusted. Therefore, examining the factors affecting the financial leverage adjustment speed can be important. This research aims to investigate the effect of economic uncertainty and investment increase on the financial leverage adjustment speed. For hypothesis testing, a sample of 130 companies listed on the Tehran Stock Exchange during the period 2016-2021 was selected, and hypothesis testing was carried out using multiple regression and panel data. The results of hypothesis testing show that economic uncertainty has a positive and significant effect on the financial leverage adjustment speed in firms with excessive financial leverage, but this effect is not significant in firms with lower financial leverage. Additionally, firms with excessive financial leverage have a slower rate of leverage adjustment during periods of investment increase than during normal periods. However, investment increase has no effect on the financial leverage adjustment speed in firms with lower financial leverage. Moreover, the results show that in conditions of investment increase, firms with excessive financial leverage and low economic uncertainty have a leverage adjustment speed close to zero, while economic uncertainty has no effect on the financial leverage adjustment speed in firms with lower financial leverage during periods of investment increase.IntroductionMany studies on capital structure have shown that firms continuously adjust their financial leverage based on changes in their internal and external environment to maximize their financial security, financing, and value. One of the factors affecting the financial leverage adjustment speed of firms is the uncertainty of economic policies. Economic policies including monetary, financial, regulatory, and tax policies, shape the business environment. Economic uncertainty can be a major reason for the financial leverage adjustment speed of firms due to its intangible nature (Dang et al., 2012; Fernando et al., 2021; Im et al., 2022). On the other hand, periods of investment growth provide valuable opportunities to achieve a theoretical framework for corporate capital structure decisions because major investments usually require external financing (Tan et al., 2021). Therefore, this study examines the impact of economic uncertainty on the speed of adjustment of financial leverage and the role of economic uncertainty in the intensity of the effect of investment growth on the financial leverage adjustment speed in firms with excessive and lower financial leverage. Methods & MaterialA sample of 130 companies listed on the Tehran Stock Exchange during the period 2016-2021 was selected for testing hypotheses. Multiple regression and panel data were used to examine the hypotheses. The dependent variable is the financial leverage adjustment speed, and the independent variables are economic uncertainty and investment growth. The research hypotheses were examined separately in companies with excessive and lower financial leverage.FindingThe study's findings reveal that high economic uncertainty in firms with excessive financial leverage leads to an increase in the speed of financial leverage adjustment. However, in firms with less financial leverage, economic uncertainty has no significant effect on the speed of adjustment. The results also suggest that firms with excessive financial leverage exhibit a slower leverage adjustment speed during periods of increased investment. Conversely, firms with less financial leverage are unaffected by an increase in investment and exhibit no significant difference in the speed of leverage adjustment. Furthermore, other findings have also shown that in firms with excessive financial leverage and low economic uncertainty, an increase in investment does not impact the financial leverage adjustment speed. Finally, contrary to expectations, in conditions of increased investment, firms with lower financial leverage and less uncertainty do not have a greater leverage adjustment speed. Conclusion & ResultsWhen there is high economic uncertainty and a firm has excessive debt, then due to pressure from financial suppliers, firms are forced to reduce their debt. As a result, the financial leverage adjustment speed increases. In firms with less-than-optimal levels of financial leverage, since the leverage ratios of such firms are almost below the optimal level, economic uncertainty does not significantly affect the cost of increasing debt and the financial leverage adjustment speed. When there is an increase in investment in a year and the company also has excessive debt, then the increase in investment due to increased financial supply pressure causes firms to adjust financial leverage towards the target leverage at a slower pace. To avoid the direct and indirect costs of increasing financial leverage, such firms try to finance the increase in investment from other sources rather than increasing financial leverage. In firms with excessive financial leverage and low economic uncertainty, an increase in investment did not have much effect on the financial leverage adjustment speed. This could be because if the increase in investment is reliant on financing debt, highly leveraged firms facing low economic uncertainty will deviate from their leverage goals during the investment period and the financial leverage adjustment speed will become negative or close to zero. Ultimately, contrary to expectations, it was observed that in conditions of increased investment, firms with less financial leverage did not have a higher speed of adjusting their financial leverage than those with excessive financial leverage facing low uncertainty. This is probably because in firms with less financial leverage facing low uncertainty, financing investment through debt is not possible and managers use other options such as issuing shares. * Corresponding author

Keywords

• financial leverage adjustment speed
• economic uncertainty
• investment