Do Markets Anticipate Capital Structure Decisions? Feedback Effects in Equity Liquidity

This paper uses a new perspective to analyze information obtained from capital structure decisions. Most previous studies either separately tested how firms adjust to leverage targets, or observed how financial policy changes convey information such as balance sheet items. However, we analyze the impact of expected (targeted) capital structure decisions on information asymmetries. We measure the latter by using equity liquidity. The effect is based on the assumption that one of the main drivers of liquidity is the information asymmetry that exists between managers (insiders) and owners (outsiders). For our empirical analysis, we use an information asymmetry index based on six measures that capture trading activity, trading costs, and the price impact of order flow. Under the assumption of joint determination of leverage and liquidity, we find that expected increases in leverage (target leverage changes) decrease our information asymmetry index. This is consistent with the signalling hypothesis of Ross (1977), and is equivalent to increases in equity liquidity