The Relationship between Leverage and Investment

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For many years, the relationship between leverage and investment opportunities has been a topic of interest among finance scholars. Recent empirical studies, for instance, Lang et al., (1996) and Aivazian et al., (2005) show that leverage and investment opportunities are negatively related. There are good reasons to believe that at low to moderate debt ratios, further increases in debt ratio lower the required rate of return for initiating investment projects and therefore, more highly leveraged firms should invest more when considering the impact of leverage on the cost of capital. Under the original Modigliani-Miller propositions, leverage and investment were unrelated. If a firm had profitable investment opportunities, it could obtain funding for these opportunities regardless of the nature of its current balance sheet. However, the capital structure literature has argued that leverage and investment opportunities are strongly related. It is essential to distinguish between over investment and underinvestment when talking about investment. In a seminar work performed by Myers (1977), it was stated that high leverage overhang decreases the incentives of the shareholder-management coalition in control of the firm to invest in positive net present value of investment opportunities, since the benefits are accumulated to the bondholders rather than to the shareholders. Therefore, firms with low levels of leverage are more likely to exploit valuable growth opportunities as compared to highly levered firms. A related underinvestment theory centers on a liquidity effect such that there is low investment no matter a firm's growth opportunities if the firm has large debt commitment. Literature has argued that underinvestment incentives are likely to occur especially when firms are highly indebted. Over-investment theory is another possible agency problem where the problem is between managers and shareholders. Managers perceive an opportunity to expand the business even if that means undertaking poor projects and reducing shareholder welfare. Management's ability to carry out this policy is limited by the availability of cash flow and further tightened by the financing of debt. Leverage is hence, a way for overcoming the overinvestment problem showing a negative relationship between debt and investment for firms with low growth opportunities. Whether debt financing induce firms to make over-investment or under-investment is debatable. Taking loans commits a firm to pay cash as interest and principal and managers are forced to serve such commitments. However, too much debt is considered to be bad as it may lead to financial distress and agency problems.

According to Jensen (1986) when firms have more internally generated funds than positive NPV investment opportunities, the presence of debt in the firm's capital structure may force managers to utilize the funds in servicing the debt which could have been utilized in investing in negative NPV projects at the detriment of the shareholder's interest. Such situation can be coined as the over investment problem. Therefore, debt financing can be utilized as an instrument to curtail the over-investment problem by forcing managers to pay out excess funds to service debt. Hence, for these types of firms, debt financing has a positive impact on the value of the firm.

Whited (1992) demonstrated how investment is more sensitive to cash flow in firms with high leverage as compared to firms with low leverage. Furthermore, Cantor (1990) showed that investment is more sensitive to earnings for highly levered firms. Kopcke and Howry (1994) used balance sheet variables as separate regressors in the investment equation and argue that these effects are not important. The Modigliani Miller Theorem (Modigliani and Miller, 1958, 1961) demonstrates that the value of a firm and the investment decisions should be independent from its capital structure. In other words, leverage should have no effect on investment decisions. However, the Modigliani Miller Theorem assumes a world with no taxes, information asymmetries or agency costs. Later theories argue that leverage clearly can matter due to the effect of taxes, information and agency costs (Myers, 2001). Many empirical literatures have challenged the leverage irrelevancy theorem of Modigliani and Miller. The irrelevancy proposition of Modigliani and Miller will be suitable only if the perfect market assumptions underlying their analysis are satisfied. The interactions between management, shareholders, and debt holders will generate frictions due to agency problems and that may result to underinvestment or over investment incentives. Modigliani et al (1963) argued that we should not 'waste our time worrying capacity on second-order and largely self correcting problems like financial leverage.' It means that firms should not be worried about growth if they are having good projects in hand since they will be able to find means of financing those projects. The tradeoff theory states that firms look for debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The pecking order theory says that the firm will borrow, rather than issue equity, when internal cash flow is not sufficient to fund capital expenditure. Firms prefer debt to equity because of the information investors infer from the decision to issue equity (Myers and Majluf, 1984, and Myers, 1984). An equity issue might signal to investors that the shares are overvalued, causing borrowing to become the better choice.

Theory also supports that leverage matters due to the effect on agency costs. Leverage is predicted to reduce the agency costs from the manager-shareholder conflict, thereby mitigating the investment inefficiency resulting from this conflict. Increased leverage has this effect by reducing the free cash flows for self-serving managers to waste in negative NPV projects Jensen (1986). Furthermore, Jensen argues that debt also imposes strong control effects on managers. Debt holders can exert a stronger control of the firm than shareholders. A promise to shareholders to payout a certain amount in dividends is considered weak since it is not binding (dividends can be reduced in the future). Debt creation, however, forces managers to effectively bond their promise to pay out future cash flows. The debt holders have the right to take the firm to bankruptcy court if the firm cannot make its debt service payments. The threat caused by failure to make debt service payments serves as an effective motivation force for managers to make their firms more efficient. Thus, through the reduction of free cash flows and control effects, leverage is presumed to mitigate the manager-shareholder conflict and overinvestment. As explained above, leverage worsens the shareholder-debt holder conflict. Leverage exacerbates overinvestment through asset substitution or underinvestment through debt overhang by increasing the default risk.

Hence, the analyses of Myers (1977), Jensen (1986) and Stulz (1990) predict that leverage has an important impact on investment policy. In the model of Myers (1977), debt can create an 'overhang' effect in which the firm can find it difficult to fund new projects because of the payoff from these projects would go to old claimants. If the firm has sufficiently valuable (i.e, positive Net Present Value) projects, this debt overhang effect can reduce value. Jensen (1986) emphasizes on the fact that if the firm has a few profitable growth opportunities, debt can serve a valuable bonding role, by limiting the ability of managers to invest in negative NPV projects. Stulz (1990) provides a formal model of debt choice in which debt limits managerial discretion over the firm's undistributed cash flows. In his model, the optimal debt ratio reflects a tradeoff of the underinvestment and overinvestment possibilities as stated in Myers (1977) and Jensen (1986) respectively.

Empirical evidence

From the above literature, it has been found that leverage constraints investment, firms with valuable growth opportunities should choose lower leverage in order to avoid the risk of being forced to evade some of the opportunities, and debt increases value in firms with poor growth opportunities, but decreases value in firms with profitable growth opportunities. The below existing empirical literature mostly support these propositions.

There is support for the overinvestment and the underinvestment theories in the extant empirical literature. McConnell and Servaes (1995) examined a large sample of non-financial firms in US for the years 1976, 1986, and 1988. For each year, they separate their samples into two groups, namely those with strong growth opportunities and those with weak growth opportunities. They found that there is a negative relation between the corporate value and the leverage of firms with strong growth opportunities usually indicated by high Tobin's Q, and positively correlated with leverage for firms having weak growth opportunities or low Tobin's Q. Furthermore, the allocation of equity ownership between corporate insiders and other types of investors is more important in low growth firms rather than high growth firms.

Lang, Ofek and Stulz (1996) found a negative relation between leverage and future growth in a broad sample of firms. This finding is robust to alternative measures of growth and leverage and is not driven by an endogenous relation between leverage and growth opportunities. Lang, Ofek and Stulz (1996) report that the negative relation between leverage and investment exists only for low q firms. This implies that leverage does not constrain investment in those firms in which the market recognizes profitable growth opportunities.

Lang et al., (1996) demonstrated that there was a negative relationship between leverage and future growth at the firm level and for diversified firms. They analyze a large sample of US industrial firms over the period 1970-1989 and found that for only firms with weak growth opportunities, that is Tobin's q less than one, there is a strong relationship between leverage and investment. Ahn, Denis and Denis (2004) tested the relationship between leverage and investment in diversified firms, defined as those firms reporting at least two segments operating in different 3-digit SIC codes. comprising 8674 firm-years and 24 400 segment-years over the period 1982 through 1997 and their findings suggest that higher leverage appears to impose a greater constraint on investment in the high q segments of diversified firms than in the low q segments. Moreover, Aivazian et al., (2005) analysed the impact of leverage on investment on 1035 Canadian companies over 1982 to 1999. They established a negative relationship between investment and leverage and that the relationship is higher for low growth firms rather than high growth firms. The paper tested the robustness o f these results using alternative empirical models and also employed the instrumental variable approach to deal with the endogeneity problem inherent in the relationship between leverage and investment. The results provide a support to agency theories of corporate leverage. Dang Viet Anh (2007) studied the interactions between the firm's financing and investment decisions in the presence of underinvestment and overinvestment incentives. The finding shows that high-growth firms control underinvestment incentives by reducing leverage but not by shortening debt maturity ex ante. The paper also documented a negative effect of leverage upon investment ex post, supporting the hypothesis that leverage has a disciplining role for firms with limited growth opportunities. The paper uses an unbalanced panel of UK firms that was collected from Datastream which is a database that maintains both cross-sectional and time-series company accounting and financial data. The sample included 1,683 firms. Data on the interest and all the data are collected from 1995 to 2003. Odit and Chittoo (2008) attempted to explore the relationship between financial leverage and investment decisions of Mauritian firms using firm level panel data which comprises of 27 firms all listed on the SEM, sampled over a 15 year period from 1990 to 2004. The results revealed a significant negative relationship between leverage and investment for low growth firm. Furthermore, Frank and Huyghebaert (2008) exploited some of the specific characteristics of private firms to investigate the non linear and multi period aspects of theoretical asymmetric information and agency models explaining the leverage and investment relation. They used the fixed-effects regression based on a sample of 64,246 private firm-years between 1996 and 2005 which support both multi-period and non-linear implications of credit constraints as they reveal a negative impact of leverage on investment expenditures, which reduces in the debt level but never turns positive. Overall, they find no support for the agency model of underinvestment in their sample of private enterprises. Singania and Seth (2010) examined the effect of financial leverage and investment opportunities in India. The sample they used consists of 963 companies that are listed on the Bombay Stock Exchange (BSE) for the period 2004-2008. The findings of this paper suggest that there is an inverse relation between the debt ratio of the companies and their growth when tested by the pooling method of the panel data. Moreover, Gustafsson and Sunqvist (2010) assessed the effects of leverage on investment efficiency in 216 Swedish non financial listed firms and 1480 observations were collected over the period 1997-2005 and the effects are studied separately for over- and underinvesting firms. To measure investment efficiency, they employed three different measures: marginal q, absolute investments Tobin's Q. The investment efficiency of overinvesting firms was hypothesized to be improved by higher leverage. The results based on marginal q accepted this hypothesis. The absolute investments and Tobin's Q results could not accept nor reject the hypothesis, but indicated an improvement of investment efficiency for overinvesting firms as a result of increased leverage. For underinvesting firms, investment efficiency was hypothesized to decrease with leverage. The marginal q and Tobin's Q results rejected this hypothesis. The absolute investments results could only accept this hypothesis on the 10% significance level. Thus, the results of this thesis indicate that investment efficiency increases with leverage for both groups of firms. Thus, the results suggest that leverage improves investment efficiency for over- and underinvesting Swedish firms.
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