Optimal Capital Structure for S&P 500 Companies: The Impact of Financial Distress and Management Incentives

Abstract

Capital structure remains an open question in the field of corporate finance. Many fundamental questions remain unresolved, including how capital structure affects perfor- mance, what the optimal capital structure is for a firm, and whether an optimal capital structure even exists. Empirical studies using similar methodologies and samples have pro- duced contradictory findings, which makes evaluating the competing theories’ strengths and weaknesses challenging. The paper seeks to analyze whether leverage improves firm performance while identi- fying reasons for the inconsistencies in the previous literature. It uses panel data on S&P 500 companies to study the relationship between leverage and firm performance in several contexts. It first imitates the methodologies of past studies to create baseline models that facilitate comparison. Next, it introduces interest coverage and pay-performance-sensitivity (PPS) as additional controls to isolate the impact of financial distress and agency costs on firm performance. It then uses a quadratic regression specification to account for the possibil- ity that the relationship between leverage and firm performance is non-monotonic. Finally, it checks the robustness of the results across different time frames and methodological choices. The leverage coefficient is statistically insignificant in the baseline Fixed Effects mod- els and negative in the OLS models. Introducing interest coverage causes the coefficient to become positive under both models. This change in sign suggests that not including for financial distresses introduces omitted variable bias. PPS is not found to affect the relation- ship between leverage and firm performance. This may be due to weakness of the variable rather than a lack of effect of agency costs on firm performance. This paper provides evidence that firms can increase their performance by following the Tradeoff Theory framework. The positive leverage coefficient when interest coverage is controlled for suggests that leverage is beneficial for performance absent financial distress. The interaction term between leverage and interest coverage is also positive, suggesting leverage is more beneficial for stable firms. Lastly, in the quadratic model, the linear term coefficient is positive while the squared term coefficient is negative, suggesting the existence of an optimal capital structure.