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



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    • Molina is at the Pontificia Universidad Católica de Chile, Escuela de Administración. This article is derived from my doctoral dissertation at the University of Texas, Austin. I thank my advisors Andres Almazan and Sheridan Titman for their continued guidance and support. I am especially indebted to the University of Texas, San Antonio, and the Instituto de Estudios Superiores de Administración-IESA for their support during this research. For helpful comments, I am grateful to Karan Bhanot, Alex Butler, David Chapman, Jay Hartzell, Palani-Rajan Kadapakkam, Ayla Kayhan, Don Lien, Lalatendu Misra, Thomas Moeller, Robert Parrino, Lorenzo Preve, Tom Shively, Laura Starks, Sergey Tsyplakov, and seminar participants at the University of Texas, Austin, the University of Texas, San Antonio, the Pontificia Universidad Católica de Chile, the Instituto de Estudios Superiores de Administración-IESA, the Instituto de Empresa, the 2002 FMA meetings, and the 2002 SFA meetings. I thank John Graham for sharing his marginal tax rates data. Valuable suggestions from Rick Green (the editor) and two anonymous referees also improved the paper significantly. This paper previously circulated under the title Capital Structure and Debt Rating Relationship: An Empirical Analysis. All errors are my own.


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.