Debt, Incentives and Performance: Evidence from UK Panel Data

A large body of theoretical literature suggests that capital structure plays an important as a managerial incentive mechanism. Cross-sectional empirical studies have identified a positive effect of leverage on expected performance (measured by Q) for firms with low growth opportunities. This is consistent with the joint hypothesis that leverage is beneficial for low-growth firms (in line with Jensens free cash flow hypothesis), and that not all firms choose capital structure efficiently. However, this evidence does not take into account the endogeneity of capital structure decisions. We investigate how endogeneity affects the results using instrumental variables and allowing for dynamics. The results of earlier studies are then re-interpreted in the light of our findings.