CEO Ownership, Leasing, and Debt Financing - Statistical Data Included

Financial Management (Financial Management Association), Summer, 1999 by Hamid Mehran, Robert A. Taggart, David Yermack

Formerly, the finance literature on corporate leasing tended to place primary emphasis on tax considerations and the extent to which lease financing displaced other forms of borrowing (e.g., Franks and Hodges, 1978; Miller and Upton, 1976; and Myers, Dill, and Bautista, 1976). In recent years, however, there has been an increasing tendency to view leasing in the broader context of financial contracting (e.g., Barclay and Smith, 1995; Sharpe and Nguyen, 1995; and Smith and Wakeman, 1985). While not denying the potential importance of taxes and the substitutability between leasing and debt, this newer literature has placed greater emphasis on the relative abilities of different types of financial contracts to control agency costs.

Financial contracting theory suggests that such company characteristics as business risk and the nature of the investment opportunity set should affect contracting costs and thus the choice to lease rather than buy assets. Empirical studies have provided some support for these predictions (Barclay and Smith, 1995; Sharpe and Nguyen, 1995; and Graham, Lemmon, and Schallheim, 1998). The theoretical literature has also suggested that a corporation's ownership structure, which in turn affects managerial and investor incentives, should influence the decision to lease assets (Flath, 1980; and Smith and Wakeman, 1985). For example, a manager with a large ownership stake may prefer leasing to reduce personal exposure to obsolescence or other asset-specific risks. However, ownership structure has not yet been included as an explanatory variable in empirical studies of corporate leasing behavior.

In this study we examine ownership structure, as measured by the fraction of common shares owned by the company's chief executive officer (CEO), as a possible determinant of corporate leasing. We also include variables that reflect business risk, investment opportunities, and tax considerations, and we explore further the interaction between leasing and other debt financing. We find that CEO ownership is positively related to companies' leasing activity, regardless of whether we include only capitalized leases or both capitalized and operating leases in our dependent variable. Our results also provide mixed evidence on the relationship between debt and leasing. Tobit estimates suggest a complementary relationship between debt and capitalized leases. However, we do not find evidence of a significant interaction between debt and operating leases.

In Section I, we review some elements of financial contracting theory to generate hypotheses about the determinants of leasing and debt financing. In Section II we review the principal findings from previous empirical studies of leasing. We present our own empirical specification in Section III and discuss data and measurement of variables in Section IV. In Section V, we present our empirical results, and we offer conclusions in Section VI.

I. Financial Contracting

A well-designed financial contract can enhance corporate value in at least three ways. First, contracts can transfer different forms of risk to those parties who are able to bear them most cheaply. Second, contracts affect the incentives of the contracting parties. They can afford positive incentives for agents to take value-maximizing actions, as in the case of executive stock options, or they can be used to mitigate perverse incentives, as in the case of restrictive debt covenants. Third, it may be possible through financial contracts to transfer tax liabilities from heavily taxed to more lightly taxed parties.

Firms may choose from a wide range of financial contracts in their efforts to balance risk-sharing, incentive, and tax considerations most efficiently. These include common and preferred stock, debt with different maturities and indenture provisions, and operating and financial leases. The financial contracting literature has identified four company characteristics that influence the choice among these contractual forms in financing a new asset: the company's ownership structure, the nature of its investment opportunities, its business risk, and its tax-paying status.

A. Ownership Structure

Ownership structure includes such features as the proportion of company stock owned by top management and the presence or absence of large blockholders. These features can influence managerial incentives and the effectiveness of shareholder monitoring of management, as described in the agency theory of Jensen and Meckling (1976). Fixed claims in general expose management to greater personal risk, but they help reduce agency costs by forcing the payout of free cash. Managers in firms with dispersed ownership may choose to reduce personal risk by relying less heavily on debt financing. However, managers with significant ownership stakes may use more debt financing, because, as shareholders, they reap its agency cost-reducing benefits. In addition, Kim and Sorensen (1986) point out that debt financing can allow managers with high ownership shares to maintain their control over the firm.