Are Leases and Debt Substitutes? Evidence Form Capital Structure Adjustment

Traditional finance theory suggests that leases and debt are substitutes. Ang and Peterson (1984) however, present a puzzle by showing that leases and debt are instead complements to each other. A large body of literature has developed since Ang and Peterson (1984), but the empirical evidence is inconclusive. We view the leasing puzzle from the perspective of the trade-off theory of capital structure. Specifically, we examine the relation between leases and debt using firm’s deviation from the target leverage. We find that firms that are under levered (over levered) exhibit higher (lower) lease intensity. Our results support the hypothesis that leases and debt are substitutes and are robust to alternative measure of both lease intensity and target leverage.