Abstract
The study strives to examine the effect of financial leverage on financial performance in a developing country context using two OLS regression models based on panel data consisting of 816 cases (48 companies x 17 years). Financial performance is measured using ROA, ROE, EPS, and Tobin’s Q, and financial leverage is measured using the debt-assets ratio and debt-equity ratio. It is observed that ROA and Tobin’s Q are negatively correlated with financial leverage, which is in line with the assumptions of the pecking order theory, market timing theory, and many empirical studies. However, financial leverage has a positive effect on ROE and no effect on EPS. These results are also consistent with the MM theorem, static trade off theory and many other empirical studies. Yet again, the two OLS models have put forward conflicting results while taking EPS as the dependent variable. The results corroborate the inefficient use of debt capital and suggest the need to improve the reliability of accounting information.
Highlights
Corporate financial managers should set their capital structure in such a way as to minimize the cost of capital and thereby maximize the value of the firm
The descriptive statistics are presented for understanding the nature of data and the correlation matrix for the variables is reported in order to examine the relationships that exist among the variables
These results suggest that financial leverage has statistically significant positive effect on return on equity (ROE) and earnings per share (EPS)
Summary
Corporate financial managers should set their capital structure in such a way as to minimize the cost of capital and thereby maximize the value of the firm. This is a crucial decision for business entities because managers strive to select the most appropriate debt-equity mix from different levels of financial leverage. In the absence of consensus concerning the optimal capital structure, it is pertinent to investigate the effect of financial leverage on firm performance.
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