We develop and test a fnancial exibility hypothesis (FFH) which suggests that the demand for fnancial exibility, characterized by future investment opportunities relative
to expected future cash flows and financing constraints, is the main driver of firms` capital structure decisions. Consistent with the FFH, we find a inverted-U relationships between leverage ratio and some firm characteristics: small developing firms with negative or low earned capital/oper-ating cash flows, no credit ratings, and no dividend payouts have lower leverage ratios, not because of internally generated funds but because they issue much more equity than debt to ease their lack of fnancial exibility; medium growing firms with mediocre earned credit/operating cash flows, ample growth opportunities and credit ratings have high leverage ratios by issuing debt against large future expected cash flows; and large mature firms with high earned capital/operating cash flows, good credit ratings, and large dividend payouts have moderate leverage as they rely on internal funds and use only safe debt in order to preserve fnancial exibility. The FFH explains several capital structure puzzles' raised in the literature and can be a prominently alternative to existing ones. It also provides important implications for other fnancial decisions such as dividend and cash holding policies.