How leverage affects agency cost: Investigating a non-linear relationship in Pakistani firms
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Date
2012
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Abstract
This study tests the agency cost hypothesis that use of debt decreases agency cost. This relationship has
been tested using data of 265 non-financial companies listed on Karachi stock exchange during the
period of 2004-2009. Assets utilization and General& Administrative expense ratio are used as proxy
to measure agency cost. As suggested by Jensen and Meckling (1976) that relationship between
leverage and agency cost may not be monotonic and excessive high leverage may have positive effect
on agency cost. To test this possibility non-linear regression model has also been included. We find
evidence in support of agency cost hypothesis. Results show that total debt reduces agency cost. We
also find some evidence of non-linear relationship between total debt and agency cost. In Pakistan nonfinancial
companies at total debt ratio of above 60% the diminishing effect of leverage on agency cost
starts to diminish and regression results give some evidence that further increase in leverage increases
total agency cost. This study also provides implication for the debt holders as well as the policy makers
on the use of debt in total financing of a firm.
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Keywords
Non-Financial Firms, Assets Utilization, General Expense, Administrative Expense
Citation
Innova Ciencia Vol 4, No. 9; 2-20, Sep 2012