High Leverage Firms Research Articles

Doubling Down on Debt: Limited Liability as a Financial Friction

We investigate how a combination of limited liability and preexisting debt distort firms' investment and equity payout decisions. We show that equity holders have incentives to ``double-sell'' cash flows in default, leading to overinvestment, provided that the firm has preexisting debt and the ability to issue new claims to the bankruptcy value of the firm. In a repeated version of the model, we show that the inability to commit to not double-sell cash flows leads to heterogeneous investment distortions, where high leverage firms tend to overinvest but low leverage firms tend to underinvest. Permitting equity payouts financed by new debt mitigates overinvestment for high leverage firms, but raises bankruptcy rates and exacerbates low leverage firms' tendency to underinvest---as the anticipation of equity payouts from future debt raises their cost of debt issuance. Finally, we provide empirical evidence consistent with the model.

Industry Dynamics and Capital Structure (Non)Commitment

We develop a competitive equilibrium model of leverage and industry dynamics absent of equity holders’ commitment to future debt levels. Shareholders determine the debt adjustment together with production, entry and exit decisions in response to firm-specific technology shocks. Non-commitment gives rise to debt issuance, which increases the cost of debt financing. Consequently, the entry barrier is raised, hindering entries into the market. Meanwhile, the resultant higher output price alleviates debt-equity conflicts for firms already in the industry. More importantly, non-commitment increases the mass of high-leverage firms, reshaping the distribution of the firm universe and escalating industry turnover and leverage. The results are aligned with empirical distribution features, suggesting debt-equity conflicts at the firm level can have a profound influence on industry dynamics.

Crossing the Credit Channel: Credit Spreads and Firm Heterogeneity

We show that credit spreads rise after a monetary policy tightening, yet spread reactions are heterogeneous across firms. Exploiting information from a unique panel of corporate bonds matched with balance sheet data for US non-financial firms, we document that firms with high leverage experience a more pronounced increase in credit spreads than firms with low leverage. A large fraction of this increase is due to a component of credit spreads that is in excess of firms' expected default -- the excess bond premium. Consistent with the spreads response, we also document that high-leverage firms experience a sharper contraction in debt and investment than low-leverage firms. Our results provide evidence that balance sheet effects are crucial for understanding the transmission mechanism of monetary policy.

Crossing the Credit Channel: Credit Spreads and Firm Heterogeneity

We show that credit spreads rise after a monetary policy tightening, yet spread reactions are heterogeneous across firms. Exploiting information from a unique panel of corporate bonds matched with balance sheet data for US non-financial firms, we document that firms with high leverage experience a more pronounced increase in credit spreads than firms with low leverage. A large fraction of this increase is due to a component of credit spreads that is in excess of firms' expected default -- the excess bond premium. Consistent with the spreads response, we also document that high-leverage firms experience a sharper contraction in debt and investment than low-leverage firms. Our results provide evidence that balance sheet effects are crucial for understanding the transmission mechanism of monetary policy.

Corporate Taxes and Retail Prices

We study the impact of corporate taxes on barcode-level product prices using linked survey and administrative data. Our empirical strategy exploits the dichotomy between the location of production and the location of sales, providing estimates free from confounding demand shocks. We find significant effects of corporate taxes on prices with a net-of-tax elasticity of 0.17. The effects are larger for lower-price items and products purchased by low-income households and weaker for high-leverage firms. Approximately 31% of corporate tax incidence falls on consumers, suggesting that models used by policymakers significantly underestimate the incidence of corporate taxes on consumers.

Trade credit and the speed of leverage adjustment

PurposeThe purpose of this paper is to examine the impact of trade credit on the speed of adjustment (SOA) of short-term leverage. Bankruptcy cost is higher for over-levered firms, generating a good incentive to use trade credit as a lower cost substitute; hence, firms adjust capital more quickly.Design/methodology/approachFirm-level data are used from five countries, in two different economic orientations, during the period 2000–2017: bank-oriented economies include France, Germany and Japan, and market-oriented economies include the UK and the USA. First, using the two-step GMM the study estimates the target short-term leverage ratio. Then, it examines the impact of trade credit on the SOA of the actual leverage towards the target leverage ratio.FindingsIt finds a positive impact of a low amount of trade credit (high capacity) on the SOA for over-levered firms. This is in line with the substitution effect, where the bankruptcy cost is higher for over-levered firms, which leads them to substitute bank loans with trade credit.Research limitations/implicationsThe study uses data from publicly traded firms; data from non-listed and small firms may be considered as a good opportunity for future research.Practical implicationsThe policy implication that can be derived from the empirical results is that firms’ management should recognise the relationship between trade credit and deviation from target short-term leverage. During periods of high short-term leverage firms should use trade credit as a source of finance when adjusting the short-term leverage towards the target ratio.Originality/valueThis study is the first to examine the influence of trade credit on the SOA.

Moderating Effects of Firm Size and Leverage on the Working Capital Finance–Profitability Relationship: Evidence from China

We evaluated the moderating effects of firm size and leverage on the working capital finance (WCF)–profitability relationship among Chinese companies during 2000–2017. Applying the generalized method of moments (GMM) technique on panel data, we observed that firm size and leverage have strong moderating roles in the WCF–profitability relationship. We observed that small or low-leverage firms have an inverted U-shaped WCF–profitability relationship. However, this relationship is U-shaped for large or high-leverage firms. We report break-even points in these relationships that show the portion of short-term debt in working capital financing. The results reveal that the break-even point for all subgroups (small, large, low-leverage, and high-leverage firms) decreases compared to the break-even point of the full sample. This study shows how the break-even point of the WCF–profitability relationship shifts when a company expands or its leverage level changes. Managers can use this information for profit maximization.

Does Leverage Constrain Real and AEM Around IPO Corporate Event? Evidence from the Emerging Market

The article investigates whether Malaysian initial public offering (IPO) firms engage in real and accrual earnings management (AEM) and examines the impact of leverage on the earnings management’s discretionary behaviour of the firms for the period of 2003–2013. The Dechow, Sloan, and Sweeney (1995, The Accounting Review, 70[2], 193–225) cross-sectional modified Jones model was used to estimate discretionary accruals, while Roychowdhury’s (2006, Journal of Accounting and Economics, 42[3]), 335–370) cross-sectional models were used to investigate abnormal real activity discretionary behaviour. The results indicate Malaysian IPO firms engage in real and accrual discretionary behaviour. The graphical presentations of the earnings’ management proxies indicate higher real and AEM for high-leverage firms. Similarly, the multivariate analysis indicates a positive relationship between leverage and earnings management, which is in tandem with the agency cost of free cash flow theory and debt hypothesis. It is also consistent with the pecking-order theory of capital structure. This study suggests that regulatory agencies and standard setters should continue to improve quality of accounting reports in order to protect investors’ invested capital.

Leverage and employee compensation – the perspective of human capital

Purpose The purpose of this paper is to empirically test the predictions in Titman (1984) and Berk et al. (2010) which indicate that firms with higher leverage will pay chief executive officer (CEO) and employee more. In addition, this paper examines whether financial distressed firms utilize leverage as a bargaining tool to reduce labor costs. Design/methodology/approach This paper conducts ordinary least squares regression analysis to investigate: CEO compensation which represents critical employees and lower-level employee compensation which represents less critical employees. Empirical data consist of US publicly held companies during the period between 2006 and 2013. Findings This paper finds that firms with higher levels of leverage tend to compensate employees for their human capital risk and that financially distressed firms consider leverage a bargaining tool by which to depress labor costs, which leads to lower employee compensation as compared to that of financially healthy firms. Research limitations/implications This paper highlights the importance of keeping balance between human capital and labor costs. In the case that human capital risk might not be fully compensated by firms facing financial distress, vicious cycle could occur because a failure of considering human capital might invite unrecoverable consequence. This could be done in future research. Originality/value This paper has three contributions. First, this paper supports the Titman (1984) and Berk et al. (2010) by empirically documenting that high-leveraged firms compensate their employees for potential human capital risk. Second, this paper adds to the literature by empirically providing that human capital risk might not be fully compensated if the firms are facing financial distress. Finally, this paper contributes to the authorities by showing that employees’ interests may be sacrificed if the firm is under financial distress.

Agency Cost of Equity and Growth Rate in Relation to Returns on Capital Employed and High and Low Leveraged Firms in Nigeria

This study empirically examined the theoretical predictions of agency, trade-off and pecking order theories of leverage in relation to agency cost of equity and growth rate using secondary data derived from census sampling of manufacturing, financial services (banking and insurance) firms quoted on the Nigeria Stock Exchange for the period 2013-2017. Using the same sample, the study also sought to determine the effect of agency cost of equity and growth rate on return on capital employed of high and low leverage firms. Hausman test was applied in the selection of appropriate regression model using E-Views for data analysis. Results confirm the negative relation of agency cost of equity and growth rate to leverage as predicted by agency and trade-off theories. The result also confirmed that highly profitable firms prefer internal financing to debt thus supporting the pecking order theory. Also, high leverage firms were found to post higher returns on capital employed when compared to low leverage firms implying that leverage enhances profitability. It was found that the direction of the sign of the relations of leverage and performance is swayed by the dominating subsample between high and low leveraged firms. We recommend judicious mix of equity and debt to enhance returns on investment and that regulators overhaul their monitoring mechanisms to isolate early warning signs of bankruptcy risks and earnings management.

Fair Employee Treatment and Financial Characteristics of Firms

Present paper investigates the interactions between firm’s key financial decisions and its fair employee treatment and welfare policies. Fair employee treatment has two components—measurable and unmeasurable. Certain ratios like employee compensation to sales, employee compensation to total assets, and total employee welfare to sales are computed to capture the measurable part of fair employee treatment. To envisage the unmeasurable component, a dummy variable for fair employee treatment is used which is based on the listing of the firm in India’s Best Companies to Work for 2017: The complete List prepared by Great Place to Work and published by Economic Times. Linear multiple regression analysis is conducted using firm’s leverage, price to book value, and enterprise value to EBDITA as dependent variables, and fair employee treatment, and employee compensation to sales as independent variables. Results indicate a negative relationship between employee compensation and firm valuation, and confirm that high leverage firms are more likely to cut-down on employee compensation but ensure better and fair treatment of employees. The result of binary logistic regression model predicts that firm’s dividend policy, employee stock options, and firm leverage positively impact the probability of fair employee treatment.

The role of the board and the audit committee in corporate risk management

This paper examines the impact of corporate governance on corporate risk-management activities in S&P 500 firms over the period 2004–2010 by measuring the characteristics of the board directors and audit committee. Our results show that the board of directors, especially the audit committee, plays an important role in the firm’s hedging decisions, including whether to hedge and to what extent. Such evidence is even stronger in high-leveraged firms with large risk-shifting incentives. These results are robust to the consideration of endogenous concerns, a board corporate governance index, and industrial effects. Our study contributes to the literature by showing the influential role of the audit committee on corporate risk management.

Corporate Diversification, Managerial Expansion, Firm Liquidity and Operating Performance: The Role of Segment Disclosure

We investigate the association between corporate international diversification and operating and market performance and firm spread (liquidity). We find, as expected, that foreign fixed assets of US firms are significantly and positively related to firm performance as measured by operating income, cash from operations, and liquidity. This evidence suggests that corporate international diversification reflects a unique dimension that is incremental to operating and market performance. Foreign fixed assets also are significantly and positively related to prices and returns, suggesting that foreign investments are wealth changing corporate decision. This finding not only complements our operating performance results and price regressions findings, but also suggests that a portion of US firms’ investment abroad is timely. Our inferences are robust to change specifications and controlling for previously identified determinants of spread, operating and market performance. Our price and return results suggest that investors incorporate geographic segmental assets data in their valuation model. Extending the analysis on partition sample — high versus low leverage firms, we document that both foreign assets of high and low leverage firms are significantly positively associated with share price and the coefficient on high leverage firms is significantly larger than the coefficient on low leverage firms.

Derivative Cash Flows and Corporate Investment

A crucial argument for motivating hedging is that it supports corporate investment when internal cash flows are volatile and external financing is costly (Froot, Scharfstein and Stein, 1993). Despite its vast influence, the predictions of this theory have not yet been directly tested. I investigate the relationship between derivative cash flows and investment using hand-collected data from the oil and gas industry between 2000 and 2015. The data supports the theory. On average derivative cash flows make up 16% of the financing of capital expenditure, a number that rises to over 40% in crisis periods. Investment-derivative cash flow sensitivities are close to one for high-leverage firms. Derivative cash flows furthermore reduce investment tail risk, i.e. the risk of large shortfalls in capital expenditure relative its predicted value.

Why do firms smooth dividends? Empirical evidence from an emerging economy India

The present study examines the determinants of dividend smoothing behaviour of 240 sample companies listed on National Stock Exchange (NSE) in India, which have continuous data during the period 1994-1995 to 2012-2013. The empirical results show that Indian firms have target payout ratios, adjust to their targets relatively slowly but not as slowly as the firms in the developed markets such as the USA, Germany and France and thus, tend to smooth and stable their dividends and rely on long-term target payout ratios while making the dividend payment decisions. The firms having high investment opportunities, low leveraged, riskier and smaller firms tend to smooth their dividend more. As for the macroeconomic factors, the high dividend distribution taxes imposed by the government tend the firms to smooth their dividends more. Overall, the results support the information asymmetry and agency-based explanations of dividend smoothing.

The Impact of Accounting Conservatism and Voluntary Disclosure on the Cost of Capital of Industrial Companies in Jordan

This study aims at examining the impact of accounting conservatism and voluntary disclosure on the cost of capital of industrial companies in Jordan during the period (2009-2013). Panel OLS regression analysis was employed to test the hypotheses of the study. The results of the full sample model revealed that accounting conservatism and voluntary disclosure have significant negative impacts on the firms’ cost of capital.Furthermore, the results of the sub-samples which distinguish between large and small, as well as between high and low leverage firms showed that the sub-sample of large and small firms conforms to the full sample results. Across the sub-sample of high leverage firms, the results showed that only voluntary disclosure has a significant negative impact on the firm’s cost of capital. On the other hand, only accounting conservatism has a significant negative impact on the firm’s cost of capital across the sub-sample of low leverage firms.

Leverage and Optimal Debt Maturity Structure

The paper studies optimal debt maturity structure and focuses on two questions: whether firms of different leverages can increase firm values by exploiting short-term and long-terms bonds and/or by dispersing debt maturity dates. The calibrated model shows that it is optimal for low leverage firms to use long-term bonds exclusively but for high leverage firms to use a mixture of two types of bonds; a more dispersed maturity structure increases firm value regardless of leverage and average maturity. The economic reasons for the results are discussed. The model reveals an intricate relationship between leverage and debt maturity structure.

Debt Refinancing and Equity Returns

Previous studies report mixed evidence on how financial leverage affects expected stock returns. Our theoretical and empirical results suggest that these inconclusive findings are driven by differences in firms' debt maturity structures and refinancing needs. In our model, the firm optimizes its capital structure by jointly choosing leverage and the mix of short- and long-term debt, which determines the firm's debt refinancing intensity. Since shareholders commit to cover potential shortfalls from debt rollover, they require a return that increases in, both, leverage and debt refinancing intensity. Our empirical results confirm this model prediction and show that firms with higher (lower) leverage earn higher (lower) stock returns when controlling for the immediacy of debt refinancing. The return differential of high-leverage firms relative to low-leverage firms increases with refinancing intensity and, as also predicted by the model, is directly linked to the value premium. Accounting for differences in firms' debt maturity profiles also provides new insights for the distress puzzle.

CEO Constellation, Capital Structure, and Financial Performance

Distinctive from prior research that emphasizes the influences of CEO demographic characteristics on corporate financial strategies, this study uses constellation as the proxy variables for CEO psychological traits and takes into consideration demographic characteristic variables to further analyze the relationship between CEO traits and corporate financial leverage, performance, and growth opportunity. This is an interesting issue worthy of study because shareholders and potential investors are always searching for CEOs that can create and increase values for the firms. The results show that there is a greater proportion of Leo CEOs in high-leverage firms, a greater proportion of Virgo CEOs in low-leverage and high-ROA firms, and a greater proportion of Pisces CEOs in both low- and high-MB-ratio firms. In addition, the CEOs with air-constellation are positively related to ROA. In general, fire-sign and earth-sign CEOs prefer high financial leverage, while air-sign CEOs are averse to such; fire-sign and air-sign CEOs have positive influences on firm profitability, while earth-sign CEOs have negative influences. Moreover, cash compensation will reduce the positive effect of air-sign CEOs on ROA.

Firm Leverage and Unemployment During the Great Recession

We argue that firms’ balance sheets were instrumental in the propagation of shocks during the great Recession. Using establishment-level data, we show that firms that tightened their debt capacity in the run-up (“high-leverage firms”) exhibit a significantly larger decline in employment in response to household demand shocks than firms that freed up debt capacity (“low-leverage firms”). In fact, all of the job losses associated with falling house prices during the Great Recession are concentrated among establishments of high-leverage firms. At the county level, we find that counties with a larger fraction of establishments belonging to high-leverage firms exhibit a significantly larger decline in employment in response to household demand shocks. Thus, firms’ balance sheets also matter for aggregate employment.