Corporate Governance and Financing Policy: New Evidence

Prior research has documented evidence that entrenched managers tend to avoid debt. Contrary to this evidence, I find that firms with weak shareholder rights, as measured by the Gompers et al. (2003) governance index, actually use more debt finance and have higher leverage ratios. I provide an explanation by showing that entrenched managers choose conservative (safe) investment policies and then trade-off expected bankruptcy costs with tax shields of debt at higher leverage levels. Consistent with this, I find evidence that firms with weak shareholder rights have lower bond yields when issuing debt, enjoy higher credit ratings, and have a higher propensity to engage in conglomerating mergers. To address the potential endogeneity of the governance index, I use the exogenous shock to corporate governance generated by the adoption of state anti-takeover laws and find that managers increase leverage when they are less vulnerable to takeovers. ∗ I am grateful to Heitor Almeida, Yakov Amihud, Malcolm Baker, Michael Hertzel, Steven Kaplan, Augustin Landier, Michael Lemmon, David Mauer, Jianping Mei, René Stulz, Lawrence White, participants of the Strategy Seminar at the NYU Stern School of Business, the Doctoral Consortium Seminar at the 2004 FMA Meetings, and especially my advisors, Kose John, Daniel Wolfenzon, Jeffrey Wurgler, and Bernard Yeung, for valuable discussions. I thank David Yermack for help with Moody’s ratings migration dataset and Edwin Elton for help with Lehman Brothers fixed income database. This study has been supported by the Paul Willensky fellowship at the Leonard Stern School of Business of New York University.