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Capital structure decisions, agency conflicts and corporate

performance: Evidence from Sri Lankan listed

manufacturing firms
Ratnam Vijayakumaran
Department of Financial Management, University of Jaffna, Jaffna, Sri Lanka.

Corporate capital structure decisions are key determinants of firm performance. The agency theory
suggests that debt financing is one of the mechanisms to mitigate agency problems and thus to improve
firm performance. This paper provides important evidence on the performance effects of capital
structure decisions using a panel of listed manufacturing firms in the Colombo Stock Exchange (CSE)
over the period 2008-2013. The Generalized Method of Moments (GMM) methodology is used to
control for unobserved heterogeneity, endogeneity of capital structure decisions, and their dynamics.
The study documents that leverage is non-linearly (U-shaped) related to firm performance.

Keywords : Capital structure, agency problems, endogeneity, performance, Sri Lanka

1. Introduction Conflicts of interests between managers and

shareholders arising from the separation of
The seminal work of Modigliani and Miller ownership and control in corporations create
(1958) which led to the modern theory of capital considerable agency costs for the firms and to the
structure argues that capital structure is irrelevant economy as a whole (Berle and Means, 1932;
to the value of a firm under perfect capital market Jensen and Meckling, 1976). Yet, several
conditions. However, in practice, the existence of governance mechanisms have been devised to
market imperfections such as taxes, asymmetric mitigate agency conflicts in the firms. Agency
information and agency problems makes capital theory suggests that one such mechanism is debt
structure decisions relevant to the value of the financing. Greater debt financing may provide
firms (Modigliani and Miller,1963; Jensen mangers with the incentives to reduce agency
Meckling, 1976; Myers, 1977; Myers and costs through the threat of liquidation, which
Majluf, 1984). These theories suggest that firms' causes personal losses to managers in terms of
choices of debt and equity in their capital salaries, reputation, perquisites, etc. (e.g.,
structure have impacts on firm performance. Grossman and Hart,1982; Williams, 1987), and
More specially, Jensen Meckling, (1976) argue through pressure to generate cash flow to pay
that even in the absence of taxes debt capital can interest expenses(Jensen, 1986).
have significant effects on corporate perfor- By contrast, research argues that in
mance. emerging markets including Sri Lanka, the major
agency problem is conflict of interests between

International Journal of Accounting & Business Finance 01 Issue I - 2015

majority shareholders/ controlling shareholder potential endogeneity arising from reverse
and minority shareholders (Faccio et al., 2001; causality (Berger and Bonaccorsi di Patti, 2006)
Morck et al., 2005, Senaratne and Gunaratne, or dynamic endogeneity of debt (Dessi and
2007). Faccio et al. (2001) further suggest that Robertson, 2003). This study fills this important
controlling shareholders of the corporate groups gap in the literature.
(a dominant form of business in Asia and Europe) Using a dynamic modelling framework to
may prefer to use more debt capital in the capital control for control for firm heterogeneity and
structure and thus avail more resources in the endogeneity of capital structure decisions, and
firm for the expropriation of minority their dynamics, we document a strong non-
shareholders without diluting his/her controlling monotonic relationship (U shaped) between
stake or directly assuming more liabilities. Yet, levels of leverage and firm performance. This
firms in the emerging economies are found to use implies that as levels of leverage increases, debt
more short term debt in their financial structure capital is not efficiently utilized in the firm to
(Booth et al., 2001, Du et al., 2015). This suggests increase performance; instead, it may be used by
that when levels of leverage increase beyond a controlling shareholders to expropriate corporate
certain level, these firms may face high liquidity resources, which negatively affect firm
risk and default risk (Diamond, 1991) and lenders performance. Yet, after a threshold level is
may become vigilant and closely monitor firms reached, further increase in debt capital helps to
behavior (Jensen and Meckling, 1976; Hadlock improve performance by constraining
and James, 2002). Hence, controlling shareholders entrenchment behavior of controlling
may reduce their entrenchment behavior and shareholders through the threat of liquidation
align their interest with those of other and the close monitoring by the lenders.
shareholders. Taken together, these arguments This paper contributes to the existing
suggest that levels of leverage may be non- literature in several fronts. First, in advancing
linearly (U-shaped) related to corporate existing literature, we provide first evidence on
performance in emerging markets. the non-linear effects of leverage on corporate
Unlike in the developed countries, only a performance in the context of emerging
few studies have examined the impact of capital economies, specially in Sri Lanka. Previously,
structure on firm performance in the context of only Margaritis and Psillaki, (2010) empirically
Sri Lanka. For example, Manawaduge et al., examine non-monotonic relationship between
(2011) and Velnamby and Nimalathasan (2013) levels of leverage and performance for French
report a negative relationship between debt manufacturing firms.
financing and performance. However, these Second, unlike previous studies that have
studies do not examine potential non-linear looked at the relationships between capital
relationship between levels of leverage and structure decisions and firm performance based
corporate performance although previous studies on Sri Lankan financial markets, we use system
show that leverage is non-monotonically related GMM estimator to control for unobserved firm
to performance (Margaritis and Psillaki, 2010). heterogeneity and endogeneity of capital
Furthermore, although Manawaduge et al. (2011) structure decisions. Finally, in this study, we also
control for unobserved firm heterogeneity (e.g., take in to account the dynamic relationship
management quality) in their regression using between capital structure decisions and firm
fixed effects model, they do not control for performance.

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The reminder of the paper is organized as managers to disgorge free cash flow, thus it
follows. Section 2 reviews relevant literature and reduces the amount available to managers to
develops hypotheses. The model specifications over-invest. However, whereas increased leverage
and estimation methods are discussed in Section may help mitigate the agency costs of outside
3. Section 4 describes the data and descriptive equity, the opposite effect may occur for the
statistics. Section 5 discusses empirical results. agency costs of outside debt arising from
Section 6 concludes with summary and conflicts between debt holders and shareholders.
suggestions for potential avenues for future For example, Myers (1977) argues that high
research. levels of debt can lead to under investment (debt
overhang) problem due to conflicts between
2. Review of the Literature and hypothesis bondholders and stockholders over growth
2.1. Agency theory, Leverage and firm options.
performance By contrast, research based on emerging
Agency theory suggests that the separation of markets argues that the major agency problem
ownership and control in corporations and faced by firms in these countries is conflict of
information asymmetries lead to conflicts of interests between majority shareholders/
interest between managers and outside controlling shareholder and minority shareholders
shareholders as well as those between controlling (Faccio et al., 2001; Morck et al., 2005). Stulz,
and minority shareholders (Berle and Means, (1990) and Faccio et al. (2001) suggest that
1932; Jensen and Meckling, 1976; Shleifer and controlling shareholders may encourage the use
Vishny, 1986; Morck et al., 2005). For example, of more debt capital in the capital structure and
managers may exert insufficient work effort, thus avail more resources in the firm for their
over-consume perquisites, invest in unrelated expropriation of minority shareholders without
business to build empires, or otherwise fail to diluting his controlling stakes or directly
maximize firm value while controlling assuming more liabilities. Faccio et al. (2001)
shareholders may expropriate corporate resources further show that Asian institutions appear
through related party transactions at the expenses ineffective, allowing the controlling share-
of minority shareholders. Thus, agency conflicts holders of corporations lower down a pyramid to
and the resultant agency costs represent increase leverage to acquire more resources to
important issues in corporate governance and expropriate. This would suggest a negative
capital structure literature. relationship between leverage and firm
Agency theory also suggests that the choice performance.
of capital structure can act as a disciplinary Yet, another stand of research shows that
mechanism in mitigating these agency conflicts unlike their Western counterparts, firms in
and thus contributes to an improvement on firm emerging economies use more short term debt in
performance. Greater debt financing may their financial structure (Booth et al., 2001, Abor,
provide mangers with the incentives to 2011; Guariglia and Vijayalumaran, 2013; Du et
reduce agency costs through the threat of al., 2015). At the same time, Diamond (1991)
liquidation, which causes personal losses to argues that a high level of short-term debt is
managers of salaries, reputation, perquisites, etc. associated with high liquidity risk (default
(e.g., Grossman and Hart,1982; Williams, 1987). risk/bankruptcy). This suggests that when levels
Jensen (1986) argues that debt commits

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of leverage increase beyond a certain level, these firms from four emerging economies in Asia show
firms may face high liquidity risk and lenders that leverage has negative but insignificant impact
may become vigilant and closely monitor on performance. Using 167 Jordanian companies
borrower firm behavior (Jensen and Meckling, over a fifteen year period, Zeitun and Tian (2007)
1976; Hadlock and James 2002). report that a significant negative association
Taken together, these agency arguments between capital structure and firm performance
suggest that levels of leverage may be non- measured by both the accounting and market
monotonically (U-shaped) related to corporate measures. Rao et al. (2007), using a sample of
performance in emerging markets. Omani firms, show a negative relationship between
the level of debt and financial performance.
2.2 Existing evidence on the relationship In the context of Sri Lanka, a few studies have
between capital structure and corporate examined the impact of capital structure on firm
performance performance. For example, Manawaduge et al.,
McConnell and Servaes (1995) use a sample of (2011) use a sample of 155 Sri Lankan-listed firms
US firms for the years 1976, 1986, and 1988 and over the period 2002-2008 and find that most of
find that leverage is positively related toTobin's the Sri Lankan firms finance their operations with
Q in a low-growth firm whereas leverage is short-term debt capital as against the long-term debt
negatively related to Tobin's Q in a high-growth capital and provide strong evidence that the firm
firm. However, their study does not control for performance is negatively affected by the use of
potential endogeneity problem. debt capital. Their study also finds a significant
Using a sample of 557 UK firms over negative relationship between tangibility and
the period 1967 to 1989, Dessi and Robertson performance indicating inefficient utilization of non-
(2003) find that debt is positively associated with current assets. Using data of 25 manufacturing listed
firm performance when they do not control for companies over the period 2008-2012, Velnamby
endogenity of debt. Yet, they show that the and Nimalathasan (2013) examine the relationship
relationship disappear when they control for the between leverage and corporate performance. They
endogeneity in the static and dynamic modeling find that there is a negative relationship between
frame work. By contrast, Berger and Bonaccorsi leverage and firm performance.
di Patti (2006) use a sample of 7548 US firms in However, these studies do not examine any
the banking industry over the period 1990 to 1995 potential non-linear relationship between levels of
and report a positive relationship between leverage leverage and corporate performance although
and firm performance, controlling for potential previous studies show that leverage is non-
endogeneity arising from reverse causality. More monotonically related to performance (Margaritis
recently, Margaritis and Psillaki (2010) use a and Psillaki, 2010). Furthermore, although
sample of French manufacturing firms over the Manawaduge et al. (2011) control for unobserved
period 2002 to 2005 and report that leverage has a firm heterogeneity (e.g., management quality) in
non-linear (inverted U-shaped) relationship with their regression using fixed effects model, they do
performance. not control for potential endogeneity arising from
Researches focusing on emerging market reverse causality (Berger and Bonaccorsi di Patti,
also examine the relationship between leverage 2006) or dynamic edogeneity of debt (Dessi and
and corporate performance. Examples of these are Robertson, 2003). This study attempt to fill this
Krishnan and Moyer (1997) who focusing on large important gap in the literature.

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2.3 Hypothesis risk/bankruptcy). Therefore, we would expect
As in most other Asian and East European that at high levels of leverage, the incentive
countries, an important governance issue among alignment effects of debt financing overwhelm
Sri Lankan listed firms is conflict of interests the entrenchment behavior of controlling
between majority shareholder/controlling shareholders, leading to a positive relationship
shareholders and minority shareholders due to between debt and corporate performance.
highly concentrated ownership structure. As a whole, these arguments thus suggest
(Samarakoon, 1999b, Senatratne and Gunaratne, that levels of leverage may have non-linear (U-
2007). More specially, Senatratne and Gunaratne shaped) relationship with performance of listed
(2007) provide evidence suggesting that most of firms in Sri Lanka. We therefore hypothesize
the Sri Lankan companies have concentrated that:
ownership structure with a controlling shareholder
who is usually another institutional shareholder H1: There is a non-linear (U-shaped) relation-
such as the parent company or group companies, ship between levels of leverage and firms'
and are also characterized by wide prevalence of performance.
family ownership as the ultimate owners. They
also suggest that by having control rights in 3. Base line specification and estimation
excess of cash flow rights in these companies methodology
through pyramid and cross-holding structures,
the controlling shareholders can reap private 3.1. Baseline specification
benefits by expropriating minority shareholders. We initially estimate following static baseline
Furthermore, while Gunathilaka (2012) model that links corporate performance with
reports that concentrated ownership is positively capital structure decisions and firm
associated with leverage, others show that characteristics:
leverage is negatively associated with firm
performance. These studies together provide
evidence consistent with the notion that
controlling shareholders/ majority shareholders
may prefer to use more debt in the capital Where i indexes firms, t years. Table 1 provides
structure so as to gain private benefits at the definitions and expected signs for all variables
expenses of minority shareholders (see, Stulz, used in this paper. The error term in Equation (1)
1990 and Faccio et al. 2001). This would suggest is made up of two components: vt, a time-specific
a negative relationship between leverage and effect, which we control for by including time
firm performance, as found in the previous dummies capturing business cycle effects and it is
studies in Sri Lanka. an idiosyncratic component.
Another strand of research (e.g., Samarakoon Since previous studies provide strong
(1999b) and Vijayakumaran and Vijayakumarn, evidence that unobserved firm-specific fixed
2011) shows that Sri Lankan listed firms use effects, endogeneity of capital structure
more short-term debt than long term debt due to decisions and their dynamics affect the
under developed bond markets. As argued above, relationship between corporate performance and
at high levels of leverage, these firms are more debt financing (Dessi and Robertson, 2003), we
likely to face high liquidity risk (or even default estimate following dynamic model.

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performance. These include sales growth
(salgrowth), firm size (fsize), squared term of
firm size (fsize ) and tangibility (tang). This
exercise would enable us to single out the impact
The error term in Equation (2) is made up of of capital structure decisions on firm
three components. vi is a firm-specific effect; vt, a performance from other observable firm
time-specific effect, which we control for by characteristics.
including time dummies capturing business cycle Growth opportunities are proxied by growth
effects. is an idiosyncratic component. of sales which is denoted by salgrowth. Since
growth opportunities represent a firm's growth
3.1.1 Dependent variable prospects and investment opportunities, there
In this study we use two alternative proxies to should be a positive relationship between the
measure corporate performance (denoted by growth opportunities and performance. Previous
perform in equation 1and 2), namely return on empirical studies also report a positive effect of
assets (ROA) and return on equity (ROE).While growth opportunities on firm performance (see
ROA is defined as net income (net profit) Claessens et al., 2002; King and Santor, 2008).
divided by year-end total assets, ROE defined In the context of Sri Lanka, Manawaduge et al.
as net income divided by total equity. (2011) find a positive but insignificant
relationship between growth opportunities and
3.1.2 Capital structure variables firm performance.
The independent variable is total leverage Firm size (fsize) is measured by the natural
(denoted by tlev), which is used to capture the logarithm of total sales at the firm level. A
effect of capital structure decisions on corporate positive relationship between firm size and
performance. Following Dessi and Robertson, corporate performance is often considered as a
(2003) and Margaritis and Psillaki (2010), stylized fact, as larger firms are expected to use
leverage is defined as the total debt to total better technology, be more diversified and better
assets ratio. In addition, as in Margaritis and managed. Larger firms may also enjoy economies
Psillaki (2010), to account for non-linear effects of scale in monitoring top management and have a
of leverage on performance, we include a higher capacity for taking risks (Himmelberg et
squared term of leverage in the performance al.,1999; Greenaway et al., 2007 and Dixon et al.,
equation. As discussed earlier, while we would 2015). However, larger firms are likely to suffer
expect a negative relationship between leverage from hierarchical managerial in efficiencies and
(tlev) and performance and a positive thus incur larger agency costs (Williamson, 1967).
relationship between its squared term and Thus, following Himmelberg et al. (1999) and
performance. Margaritis and Psillaki, (2010), we allow for
non-linearity in the effect of firm size on
3.1.3 Control variables performance by including the square of the
In line with previous studies (e.g., Dessi and
natural log of sales in the performance equations.
Robertson, 2003; Margaritis and Psillaki, 2010),
our regression models (equations1 and 2) also Tangibility (represented by tang), is
include several additional variables to control for measured by the ratio of tangible fixed assets to
a set of firm-specific observable characteristics total assets. Diverse relationships can be
that are likely to be correlated with firms'
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observed between firms' performance and Furthermore, our estimates may be
tangibility depending on the degree of efficient affected by reverse causality. The relationship
utilization of tangible assets by the firm. If a firm between debt financing and performance may in
utilizes its tangible assets efficiently then we fact be dynamic, in the sense that on the one hand,
would expect a positive relationship between debt capital can provide incentive to managers to
tangibility and performance, otherwise the improve firm performance. Yet, on the other
relationship would be negative. hand, a firm with higher retained earnings is
Finally, following Dessi and Robertson likely to use less debt in their capital structure
(2003) and Ammann et al. (2011), to account for (Myers, 1984). It is therefore crucial to control
persistency in performance and dynamic for “dynamic endogeneity” in the study of
endogeneity of debt, we include the lagged relationship between capital structure and
dependent variable among our explanatory corporate performance (Dessi and Robertson,
variables in Equation (2). 2003).

Table 1. Variables' names, definitions and expected signs.

3.2 Estimation methodology Following Dixon et al. (2015), we use the

To examine the extent to which capital stature system GMM (Generalized Method of Moments)
decisions affects corporate performance, we first estimator (Arellano and Bover, 1995; Blundell
use Pooled OLS (Ordinary Least Square) model and Bond, 1998). The system GMM estimator
with cluster robust slandered error to estimate the estimates the relevant equation (equation 2) both
equation. However, Pooled OLS does not take in levels and in first-differences. First-
into account the potential endogeneity of debt differencing is used to control for unobserved
arising from the unobserved firm heterogeneity heterogeneity. We use all right-hand side
for examp le, manager ial ability and variables (except the dummies) lagged twice or
entrenchment (Zwiebel, 1996), which affect both more as instruments in the first-differenced
the firm's choice of capital structure and its equation, and first-differences of these same
expected performance. OLS estimator is more variables lagged once as instruments in the level
likely to provide biased estimates of the equation. The system GMM estimator addresses
coefficient on debt. the potential weak instrument problem.

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4. Sample and data set manufacturing firms' assets are financed by debt
The data used in this study are obtained from capital. With respect to the control variables
annual reports of individual companies listed on included in our baseline model, the average
the Colombo Stock Exchange (CSE) for the (median) sales growth, measured as changes in
period of 2008-2013. The sample is composed of sales, is 14.2 % (12.5%). Average size of the
all the publicly listed manufacturing firms. To manufacturing firms measured by sales is about
reduce the influence of potential outliers, we 5.28 billion rupees (2.52 billion rupees). Finally,
exclude observations in the one percent tails of the average tangible assets of the firms proxied
each of the regression variables. We then by the ratio of fixed assets to total assets is given
benchmarked the trimmed data with descriptive by 0.516 (0.368).
statistics reported in other papers to ensure that These summary statistics indicate that the
the sample was representative of the population sample used in this study is comparable to others
of non-financial firms listed on the CSE. Finally, used in prior research on capital structure
we retained all firms with at least three decisions in Sri Lanka, for example Manawaduge
consecutive years of observations, in order to et al. (2011).
enable us to use the system GMM estimator.
After this screening, we end up with a panel of 5.2 Correlation analysis
154 firm-year observations over the period 2009- Table 3 reports the Pearson correlation
2013 for our empirical analysis. coefficients between variables. Total
leverage (tlev) shows a negative and
5. Empirical results
statistically significant correlation with
firms' performance measured by ROA. This
5.1 Descriptive statistics
Table 2 presents descriptive statistics for the result is consistent with the findings of
variables used in the analysis for our pooled previous studies, for example Manavaduge
sample. The pooled mean (median) return on et al. (2011). Surprisingly, total leverage is
assets (ROA) and retur n on eq uity not significantly associated with ROE.
(ROE)are7.8% (6%) and 16.9% (12.6%), Turning to control variables, sales growth
respectively. The average total debt to asset ratio (salgrowth) exhibits a negative and in
is 50.1%, suggesting that about 50% of the significant correlation with both ROA and
Table 2. Summary statistics

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ROE. While firm size (fsize) has a significant findings suggest that there is strong evidence
positive correlation with ROA, it is of a curvilinear relationship between
positively and insignificantly associated leverage and corporate performance.
with ROE. Finally, the ratio of tangible fixed Specifically, the performance (ROA) first
assets to total assets (tang) does not have any decreases, then increases as levels of
significant association with ROA and ROE. leverage rise. At lower levels of leverage, the
Furthermore, Table 3 suggests that given negative effect of leverage strongly
that the observed correlation coefficients dominates any positive effects. The average
are relatively low, multicollinearity should turning point in leverage is 56.58%.
not be a serious problem in our study.

5.3 Multivariate analysis These results are in marked contrast to

Table 4 presents estimation results of our the theoretical predictions of Myers (1977)
baseline model (1) using pooled OLS and of and empirical findings of Margaritis and
the dynamic model (2) using system GMM Psillaki (2010) for French manufacturing
estimator, where the dependent variable is firms which suggest that at relatively higher
return on assets (ROA). In column 1 of Table levels of leverage, agency costs of debt may
4, we first estimate a static model in which overwhelm the benefits offered by it due to
the ROA is regressed on leverage, leverage the problems of under investment. Yet, our
squared and a set of control variables results can be explained by the fact that in
including sales growth, firm size and emerging markets such as Sri Lanka, firms
tangibility and a set of year dummies. In the use relatively more short-term debt than long
subsequent column, we then include lagged term debt such as bond/debenture (which is
ROA and estimate a dynamic model. more prone to underinvestment problem) and
Column (1) reports the OLS estimates. also that bank loans are major source of debt
Firstly, the coefficients on leverage and its financing, implying that when leverage becomes
square are highly significant (at the 1% relatively high, elevating both the expected costs
level). The former is negative, and the latter, of
positive. In line with hypothesis H1, these

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financial distress, bankruptcy, or liquidation of
the firms and monitoring incentives of lenders
(e.g., banks), it provides insiders and controlling
shareholders with the incentive necessary to
avoid their misconducts and to align their
interests with that of other shareholders and thus
improve firms' performance. This finding is
consistent with Saker and Saker (2006) and
Vijayakumaran (2014) who provide empirical
evidence suggesting that with the institutional
developments over the period, debt financing has
emerged as an important governance mechanism
to mitigate agency costs for firms in India and
China, respectively.
Turning to the control variables, we observe
that sales growth (salgrowth) is not significantly
associated with f i rm performance at
conventional levels. This finding is consistent
with the finding of Manawaduge et al. (2011).
The estimated coefficient on firm size (fsize) is
negative but not significant while the coefficient
of its square (fsize )is significant at the 10% level,
suggesting that large firms enjoy economies of
scale, and face less asymmetric information
problem and thus are able to obtain external debt
capital at lower cost of capital. Finally, the
coefficient associated with tangibility is negative
but not significant. Consistent with Manawaduge
et al. (2011), this result suggests that Sri Lankan
manufacturing firms do not efficiently utilize
tangible fixed assets.
The adjusted R suggests that 32.4% of the
total variance of the performance (ROA) is
explained by the model.
As discussed in Section 3, the OLS
estimates are however likely to suffer from biases
due to unobserved heterogeneity, and possible
endogeneity of the regressors. Therefore, in
column (2) of Table 4, we present the estimates
obtained with our preferred estimator, namely the
system GMM estimator which control for
unobserved heterogeneity and the possible

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endogeneity of the regressors. We use all right-
hand side variables, except the dummies, lagged
twice or more as instruments in the first-
differenced equation, and first-differences of
these same variables lagged once as instruments
in the level equation. The results show that once
again, leverage and its square still display a
negative and positive coefficient, respectively,
and are both precisely determined. This confirms
that debt capital and firms' performance are
linked by a U-shaped relationship, with turning
point of 58.39%.
Looking at the control variables, we
observe that once again, sales growth (salgrowth)
is not significantly associated with firm
performance at conventional levels. The
estimated coefficient on firm size (fsize) is
negative and significant at the 10% level, while
the coefficient of its square (fsize )is significant at
the 5% level, suggesting that large firms in fact
enjoy economies of scale, and face less
information asymmetries in the financial markets
and thus are able to obtain external debt capital at
lower cost of capital. As found in column 1 of
Table 4, the coefficient for tangibility is negative
but not significant, suggesting that Sri Lankan
manufacturing firms do not efficiently utilize
tangible fixed assets.
Finally, the estimated coefficient on the
lagged dependent variable is positive and
statistically significant, consistent with the
predictions that there is persistency in
performance and dynamic effects are important
(Dessi and Robertson, 2003).
The Hansen test and AR(2) statistics
suggest that the instruments are valid and that
there is no mis-specification in the model. dependent variable instead of ROA, using the
dynamic system GMM estimator.
5.4 Robustness tests As can be seen in Table 5, the results show
As a robustness test, we estimate our preferred that once again, leverage and it square still
model 2 with return on equity (ROE) as a display a negative and positive coefficients,
respectively, and are both precisely determined.

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This confirms that debt financing and corporate Our study has important policy implications
performance are linked by a U-shaped in that it suggests that lenders such as banks
relationship predicted by our hypothesis H1, with should closely monitor borrower firm's
turning point of 56.36%. As for the control behaviour and ensure that their loans are not
variables, they show a similar pattern as in inefficiently used or are not used by controlling
column 2 of Table 4. Furthermore, the Hansen shareholders to reap private benefits. Bank
test and AR(2) statistics suggest that the regulators may also put more restriction on the
instruments are valid and that there is no mis- use of debt capital by firms with highly
specification in the model. concentrated ownership in order to offset
controlling shareholder's incentive to use debt for
6. Conclusions private benefits. Furthermore, by providing
important evidence on the efficacy of one of the
The agency models of capital structure suggests important governance mechanisms, namely debt
that debt financing is one of the important financing, our study also provides new insight
mechanisms to mitigate agency problems and into the future directions corporate governance
thus to improve corporate performance. This reform in Sri Lanka.
study examine the non-linear relationship In the present study, we have examined
between capital structure decisions and potential governance role of total debt. In future
performance of Sri Lankan listed firms, using research, we plan to expand this study by
the system GMM estimator to control for examining how close relationship with banks and
unobserved heterogeneity, endogeneity of capital bank borrowings affect corporate performance in
structure decisions, and their dynamics. The Sri Lanka.
study uses 154 firm year observations over the
period 2009-2013. References
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