Profits, financial leverage and corporate governance

Abstract

Purpose The purpose of this paper is to identify the impact of governance structures in defining the relationship between profits and leverage. Design/methodology/approach The 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. Findings The 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/value This 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.