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Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities
Author(s) -
MOLINA CARLOS A.
Publication year - 2005
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2005.00766.x
Subject(s) - leverage (statistics) , endogeneity , debt , financial distress , capital structure , instrumental variable , business , default risk , monetary economics , economics , offset (computer science) , econometrics , actuarial science , finance , financial system , credit risk , computer science , programming language , machine learning
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.