Corporate governance and financing policy: New evidence, Working paper

Prior research has often taken the view that entrenched managers tend to avoid debt. Contrary to this view, I find that firms with weak shareholder rights, as measured by the Gompers et al. (2003) governance index, actually use more debt finance and have higher leverage ratios. I provide an explanation by showing that entrenched managers choose conservative investment policies and thus trade-off expected bankruptcy costs with tax shields of debt at higher leverage levels. Consistent with this, I find evidence that firms with weak shareholder rights have lower bond yields when issuing debt, enjoy higher credit ratings, and have a higher propensity to engage in conglomerate mergers. To address the potential endogeneity of the governance index, I use the exogenous shock to corporate governance generated by the adoption of state anti-takeover laws and find that managers increase leverage when they are less vulnerable to takeovers.