Over risk, while maximizing the firm’s value and

Over
the years, various academic researchers have tried to establish the relationship
between the proportion of debt in the total capital structure of a firm (financial
leverage), their effect on the health of the firm and the impact on managerial
practices and financing decisions.  

Firms
finance capital expenditures in several ways. One of these ways is through a
mix of debt of equity, which becomes part of the capital structure of a firm. The
proportion of equity or debt to the firm’s total capital structure then forms a
strategic firm in the making of managerial decisions, in combination with other
factors such as the size of the firm, the firm’s payout ratio and the ease of
availing external sources of financing. Capital structure decisions are
therefore important as they determine the wealth of shareholders. However,
finding the optimal capital structure is difficult since different firms use
distinct capital structures and it is difficult to find the capital structure
that minimizes cost and risk, while maximizing the firm’s value and shareholder
wealth (Nadeem, Waheed, & Mahmood,
2016).

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Kraus
and Litzenberger (1973) argue that debt comes with a cost of default or
financial distress and as the firm acquires more debt, the cost associated with
the risk of default increases. Additionally, the uncertainty associated with
the firm’s ability to service future debt obligations increases with a rise in
the amount of debt, thereby increasing the risk of default. At the same time, the
more the firm takes on debt, the more the firm could benefit from the rise in
interest tax shields (Nadeem, Waheed, & Mahmood,
2016).
Because of this variance, managers are confronted with a complex range of
factors to consider when making decisions in which debt is involved.

When
dealing with debt and equity, managers have to make an analysis that results in
the selection of the right option, which is the one that minimizes costs. These
costs include interest payments, which reduce the net incomes of firms, increased
volatility costs, which reduce the EPS, and a reduction in the proportion of
equity in a firm’s capital structure, which ends up decreasing the number of
outstanding shares (Welch, 2011). As a result, the
connection between managers and corporate level matters significantly. Still,
there is a section of experts who argue that the change in management should
have little, if any effect on corporate leverage since even when the management
changes, the costs and benefits of debt, such as tax and cost of bankruptcy,
remain the same (Frank & Goyal, 2007). Nevertheless, Myers
and Majluf (1984), presented a theory known as the Pecking Order Theory. This
theory states that firms should try by all means to avoid debt. According to
the researchers, firms must always strive to raise capital internally and report
to debt and equity financing as a last option. This is because internal sources
of funding reduce the cost of bankruptcy, lowering financial leverage (Khakwani,
Shahid, & Hamza, 2016).

Contrary
to this assertion, research findings by Frank & Goyal indicate that
management has a huge impact on corporate leverage. First, this is because managerial
turnovers, i.e. the change or firing of managers, mainly occur because the
leverage has grown above normal, especially in the last two years. This is
consistent with the assertion that debt occurs and accumulates because of poor
corporate performance. Consequently, the Board of Directors usually replaces
key managers, such as CEOs, in hopes that the replacements will lead to better
corporate leverage and therefore better corporate governance (Frank &
Goyal, 2007)e.

The
relationship between corporate leverage and management can also be approached
from the viewpoint of analyzing the impact of executive compensation leverage
adjustments. Research has found that higher pay for managers motivates and
inspires them to pursue more rapid target adjustment behavior, including the
speedy adjustment of financial leverage. However, when the CEO in particular is
paid less, there is less motivation to adjust financial leverage (Frank &
Goyal, 2007).

Different
managers handle corporate leverage differently. This could be as a result of
the difference in managerial characteristics among various types of managers. Research
has shown that personal attributes may explain the varying leverage decisions
of managers in different firms but as of now, the choices are not connected
close enough to clearly establish observable managerial traits. This could be
due to a disconnect between the characteristics of CEOs and their preferences
or because managers interpret matters in a broader fashion, overriding their
personal traits. Additionally, the Chief Financial Officer (CFO), rather than
the Chief Executive Officer (CEO), plays a key role in the determination of
corporate leverage (Frank & Goyal, 2007).

A
turnover in the firm’s CEO does not have any effect if the turnover was due to
normal reasons such as, attainment of retirement age by the CEO, poor health or
death of the reigning CEO, if a secession plan was in place at least six months
prior to the departure of the CEO and lastly, if the CEO resigns and continues
as chairman for at least a year. On the other hand, if the turnover is due to a
management shakeup or is forced, i.e. due to the departure of the CEO for
personal reasons or to pursue other interests, if the company fails to provide
an explanation for the departure of a CEO who is younger than 63 or the CEO
leaves due to corporate restructuring activities such as a merger. This is
because in most instances, just before a forced turnover, the financial
leverage is usually elevated due to poor performance but after a change in
managerial leadership, the turnover reduces and becomes normal once again. Furthermore,
when the turnover is normal, leverage adjustments occur faster than when the
turnover is forced (Frank & Goyal, 2007).

Aside
from managers, there are other aspects of corporate governance and management that
relate to corporate leverage. A study by Abdoli, Lashkary and Dehglani (2012)
on the effect of corporate governance on financial leverage, using a sample of
77 Iranian firms, revealed that the independence of the Board of Directors and the
presence of internal company auditors significantly affect financial leverage. Sabour,
Al-Farouq and Karim (2009) conducted a similar study, evaluating the
relationship between a firm’s ownership structure, the structure of the Board
of Directors, and the financial performance of companies. This particular study
was conducted in Botswana. The results of the study revealed that corporate
governance systems diversified in capital market investments with different
combinations had less financial leverage. Adeyemi and Oboh (2011) also found
that the market value of firms is directly influenced by the capital structure
decisions of the managers. When managers choose different alternatives of
capital structure, the financial leverage reduces significantly and vice versa (Yaseen &
Al-Amarneh, 2015).

Nevertheless,
Afza and Hussain showed that debt and high financial leverage may not necessarily
be a weakness for the company. According to the research, the two researchers
suggest that managers should not shy away from taking on debt as this is the
best way for the firm to highlight the trust investors have in the firm. When a
company takes on debt and investors approve, the researchers state that this
action sends a positive signal in the market. Additionally, the researchers
state that when a company takes on more debt, the implication is that the
firm’s managers have confidence in the sustainability of future cash flows, sending
another positive signal to both the investors and the market. The managers of
the firm only have to be cautious so that the increase in debt does not result
in bankruptcy, as this will greatly lower the value of the firm. Therefore,
managers should learn how to optimize financial leverage in order to maximize
the value of the firm (Khakwani, Shahid, & Hamza,
2016).

However,
the current academic research available on corporate leverage has a number of
weaknesses. First, the current research literature overlooks the fact that
leverage ratios are not linear. The current research additionally fails to take
into consideration the fact that leverage ratios are also changed by academic
performance. In market values, for instance, leverage ratios are affected by
changes in stock prices and book values, these ratios are affected by
depreciation and retained earnings. The other essential facts the research
eliminates is that firms repurchase equity, retire debt and that firms do not
just issue equity to public markets, but also for other purposes such as
compensation. Because of these weaknesses, the activity of issuing equity
should not always be seen as changes to a firm’s capital structure (Welch, 2011).

In
addition, the impact of corporate management and financial leverage is not an
easy straight-to-follow rule, despite the variety of research that all allude
to corporate management having a huge effect on financial leverage. In
practice, the influence of corporate governance on financial leverage varies
with the country, since different countries usually have different laws,
policies and institutions, which makes the relationship of financial leverage
and corporate governance unique for each of those countries (Khakwani,
Shahid, & Hamza, 2016). 

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