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Profits, financial leverage and corporate governance

Profits, financial leverage and corporate governance The purpose of this paper is to identify the impact of governance structures in defining the relationship between profits and leverage.Design/methodology/approachThe paper uses the standard design used by Fama and French (2002) and employs it under different governance structures. It is the first to identify the endogenous nature of the relationship between profits and leverage, compounded by the endogeneity of governance. The paper uses the instrumental variable (IV) technique to control for endogeneity and recommends a novel approach to control for multiple endogenous regressors.FindingsThe results demonstrate that firms operating under good governance verify the predictions of the trade-off theory of capital structure and that the evidence of negative relation in the literature is a subset of management inefficiency. The results are consistent after controlling for endogeneity and are robust to alternative iteration of governance. The activity in debt issuance and retirement supports the conclusion that firms with good governance structures actively seek an optimal capital structure corresponding to profits.Originality/valueThis study adds value to existing literature. It is the first to identify the importance of governance in defining the relationship between profits and leverage. It recognizes unaccounted endogeneity concerns and employs an inspired IV approach to control for feedback from multiple endogenous regressors. Evidence for capital structure adjustment by firms with good governance is also substantiated. Lastly, the first unqualified evidence for the trade-off model is provided. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png International Journal of Managerial Finance Emerald Publishing

Profits, financial leverage and corporate governance

International Journal of Managerial Finance , Volume 16 (2): 21 – Apr 15, 2020

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Publisher
Emerald Publishing
Copyright
© Emerald Publishing Limited
ISSN
1743-9132
DOI
10.1108/ijmf-03-2019-0091
Publisher site
See Article on Publisher Site

Abstract

The purpose of this paper is to identify the impact of governance structures in defining the relationship between profits and leverage.Design/methodology/approachThe paper uses the standard design used by Fama and French (2002) and employs it under different governance structures. It is the first to identify the endogenous nature of the relationship between profits and leverage, compounded by the endogeneity of governance. The paper uses the instrumental variable (IV) technique to control for endogeneity and recommends a novel approach to control for multiple endogenous regressors.FindingsThe results demonstrate that firms operating under good governance verify the predictions of the trade-off theory of capital structure and that the evidence of negative relation in the literature is a subset of management inefficiency. The results are consistent after controlling for endogeneity and are robust to alternative iteration of governance. The activity in debt issuance and retirement supports the conclusion that firms with good governance structures actively seek an optimal capital structure corresponding to profits.Originality/valueThis study adds value to existing literature. It is the first to identify the importance of governance in defining the relationship between profits and leverage. It recognizes unaccounted endogeneity concerns and employs an inspired IV approach to control for feedback from multiple endogenous regressors. Evidence for capital structure adjustment by firms with good governance is also substantiated. Lastly, the first unqualified evidence for the trade-off model is provided.

Journal

International Journal of Managerial FinanceEmerald Publishing

Published: Apr 15, 2020

Keywords: Trade-off theory; Leverage; Profits; Corporate governance; G3; G30; G32; G34

References