Leverage and firm value

Abstract

Three highly cited studies with over 6000 citations collectively report a negative relationship between the market value of the firm and leverage. Such empirical findings clearly contradict the hypothesis of leverage adding value to the firm and an optimal capital structure that maximizes firm value—these findings have yet to be resolved. Employing a sample of 3,768 firms consisting of 39,015 observations, a stochastic frontier analysis was used to assess the relationship of leverage among other capital structure factors with firm value. It was found that in general the use of leverage promotes firm value, consistent with the trade-off theory and that the inverse relationship between leverage and firm value was a temporary occurrence and is likely attributable to firms employing tax loss carrybacks in response to the 1986 Tax Reform Act. The estimates of technical efficiency indicate that many firms can do more to increase their value, the sample as a whole improves efficiency (value) over the sample period. The findings reconcile the reports of leverage decreasing firm value as reported in Baker and Wurgler, Fama and French, and Habib and Ljungqvist. The empirical findings suggest prior observation was a due to a decline in the value of the tax shield generated by leverage after the Tax Reform Act of 1986. Specifically, tax carrybacks extended the pre-Tax Reform Act of 1986 tax shield value to 1991 and after 1991 the tax shield value declined.