Testing the Static Trade-Off Theory of Capital Structure: A Corporate Governance Perspective

In this paper we explore the static trade-off theory of capital structure under different governance structures. We find that good governance firms have leverage ratios that are higher (forty-seven percent) than poor governance firms per unit of profit. Evidence also suggests that while the leverage ratio for good governance firms has a narrower range and adjusts with changes in profit, the same is not true for poor governance firms. Direct test of the theory finds that good governance firms exhibit a positive relationship between profits and leverage, while poor governance firms show an inverse relationship. Further tests provide evidence for the varying use of tangible assets and size in leverage increasing activities for the two classifications of firms. The results of the paper demonstrate that the mixed results of prior studies notwithstanding, leverage is increasing in profits when controlled for agency problems, and shareholder-controlled firms exhibit the results predicted by the theory