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The Impact of Macroeconomic Uncertainty on Firms Changes in Financial Leverage

There is a large literature, starting with Jensen & Meckling (1976), discussing how agency conflicts affect a firm's capital structure decisions. Evidence from early work generally indicates that entrenched managers prefer lower leverage (Berger, Ofek & Yermack (1997), Garvey & Hanka (1999)). In recent years, widely available use of indices to measure shareholder rights (for example, the Gin dex of Gompers, Ishii & Metrick (2003)) has produced new results that do not agree with these empirical findings.

Jiraporn & Gleason (2007) argue that since leverage alleviates agency problems, firms with larger agency problems should adopt higher debt ratios. They find that debt ratios are inversely related to measures for better corporate governance fora large sample of non-regulated firms between 1993-2002. John & Litov (2008) also find, over a similar period, that manufacturing firms with weaker shareholder rights use more debt financing and have higher leverage between 1993-2004.

They assume that better-governed firms are easier to monitor: it is easier for the market to distinguish between managers bad luck versus bad judgment. This allows better-governed firms to take more risks. In equilibrium, a tradeoff between expected bankruptcy costs and debt-related benefits (such as tax shields) implies that firms with riskier investments will choose lower levels of debt. Following that logic, John and Litov find that poorly governed firms will be associated with more conservative investments and higher use of debt relative to their better-governed counterparts.

The focus of this paper is to highlight the impact of macroeconomic uncertainty on the relationship between corporate governance and changes in firms financial leverage. It is reasonable to assume that economy-wide risks that are exogenous to the operation of the firm and difficult to hedge against may play an important role in any financing decision. There is strong evidence that firms time their debt issuance based on macroeconomic conditions (Korajczyk&Levy (2003)). However, prior research has not considered how the governance leverage relationship maybe affected by macroeconomic risks. This is the primary contribution of our paper.

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The Impact of Macroeconomic Uncertainty on Firms Changes in Financial Leverage