Profits, Financial Leverage and Corporate Governance

Abstract

Does corporate governance play a role in determining the interactions between financial leverage and profits? I examine the relationship between corporate governance, profits and the use of debt financing, to test the validity of the trade-off theory of capital structure. I find that firms which maintain good governance structures have leverage ratios that are higher (forty-seven percent) than those of firms with poor governance mechanisms per unit of profit. Further tests suggest that good governance firms exhibit a positive relationship between profits and financial leverage while poor governance firms show an inverse relationship. The results are robust to an estimation methodology which allows for financial leverage, profits and governance to be determined jointly, using an instrumental variable approach. The key finding of the study is that corporate governance is identified as the feature that motivates managers to use more debt to take advantage of the tax deductibility of interest. The data indicate that good governance firms issue more gross and net debt (1.4 and 3.4 times respectively) and also retire more debt (1.2 times) than poor governance firms. The results of the paper demonstrate that the mixed results of prior studies notwithstanding, leverage is increasing in profits when controlled for agency problems, and shareholder controlled firms exhibit the results predicted by the trade-off theory of capital structure.