Do Inside Ownership and Leverage Share Common Determinants

Abstract

Papers by Jensen and Meckling (1976), Jensen (1986), and Stulz (1988) suggest that a firm's leverage ratio and its level of inside ownership share common determinants. This paper examines whether inside equity and leverage are explained by a common set of variables that proxy for a firm's exposure to various market imperfections. These imperfections include the agency costs of equity, leverage-related costs, the tax advantage of debt, the costs of issuing securities, and the demand for risk-sharing by insiders. In contrast to Crutchley and Hansen (1989), but consistent with Jensen, Solberg, and Zorn (1992) and Holthausen and Larcker (1991), little evidence is found that leverage and inside equity are explained by the same variables. These results hold even after controlling for industry effects, an issue not examined by previous literature. In addition, leverage is related strongly and negatively to free cashflow, a result that is inconsistent with Jensen (1986), but consistent with the pecking order hypothesis of Myers (1984).