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Leverage, competition and financial distress hazard: Implications for capital structure in the presence of agency costs

Mehmet Ugur (), Edna Solomon and Ayaz Zeynalov

Economic Modelling, 2022, vol. 108, issue C

Abstract: Does leverage or product-market competition increase or decrease financial distress risk? The existing literature provides conflicting and largely a-theoretical answers. Drawing on agency theory, we hypothesize that leverage and competition are incentive-alignment mechanisms with non-monotonic and substitute effects on financial distress hazard. Using an unbalanced panel of 13,896 listed firms from 1992 to 2014 and a multi-level hazard model that takes account of frailty and endogeneity, we find that leverage or competition have a hazard-reducing effect when the discipline effect dominates the agency-cost effect. In contrast, they have a hazard-increasing effect when the agency-cost effect dominates the discipline effect. Furthermore, the level of leverage that minimizes financial distress risk is higher in less competitive industries. Finally, long-term debt is a stronger disciplining device compared to short-term debt; and the financial distress predictors widely used in the literature explain only a small fraction of the distress hazard after controlling for leverage and competition.

Keywords: Financial distress; Competition; Leverage; Hazard modeling (search for similar items in EconPapers)
JEL-codes: C23 C25 C41 G30 G33 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.econmod.2021.105740

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