Leasing and Credit Capacity: Evidence from Borrowing Costs and Credit Ratings

Abstract

In this paper we examine the role of off-balance sheet leasing in determining firm borrowing costs and credit ratings. Borrowing costs increase and credit ratings decrease as firms add debt, whether on or off balance sheet. However, we find that borrowing costs and credit ratings are more sensitive to balance sheet debt than to off balance sheet financing (i.e., leasing). This finding suggests that leasing does not fully substitute for debt, but instead can expand total credit capacity. Consistent with theoretical predictions, leasing is more advantageous (lower impact on the cost of debt) for firms that are financially constrained (Eisfeldt and Rampini, 2009) and have lower marginal tax rates (Lewis and Schallheim, 1992), i.e., those who stand to benefit the most from additional access to capital. We also find evidence that firms closer to ratings borderlines are more likely to lease, particularly those firms just around the investment grade borderline. Our evidence from borrowing costs, credit ratings and lease financing decisions is consistent with the idea that leasing allows some firms to expand their credit capacity.