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Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities

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  • CARLOS A. MOLINA

Abstract

A commonly held view in corporate finance is that firms are less leveraged than they should be, given the potentially large tax benefits of debt. In this paper, I study the effect of firms' leverage on default probabilities as represented by the firms' ratings. Using an instrumental variable approach, I find that the leverage's effect on ratings is three times stronger than it is if the endogeneity of leverage is ignored. This stronger effect results in a higher impact of leverage on the ex ante costs of financial distress, which can offset the current estimates of the tax benefits of debt.

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  • Carlos A. Molina, 2005. "Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities," Journal of Finance, American Finance Association, vol. 60(3), pages 1427-1459, June.
    • Handle: RePEc:bla:jfinan:v:60:y:2005:i:3:p:1427-1459
    DOI: 10.1111/j.1540-6261.2005.00766.x
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