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

  • Author(s): CARLOS A. MOLINA
  • Published: May 03, 2005
  • Pages: 1427-1459
  • DOI: 10.1111/j.1540-6261.2005.00766.x

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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