The influence of financial leverage on investment : an examination of overinvestment and underinvestment in Danish listed companies

In this report the relationship between leverage and investment is examined. The relationship between leverage and investment is used to indicate the presence and extent of the agency problems overinvestment and underinvestment in Danish listed companies between the years 2006-2010. This thesis additionally focuses on the effect of managerial and institutional shareholdings on the leverage-investment relationship and the agency problems. The research question in this thesis is ‘To what extent does leverage influence investment of Danish listed companies and to what extent can the relationship be explained by agency problems?’. Past literature has focused on the relationship between leverage and investment, and the agency problems. The literature is contradictive because empirical evidence is found supporting and not supporting the agency problems. Literature is also contradictive about the effects of insider share ownership on the agency problems. Insider shareholders can align the interests of managers and shareholders and decrease overinvestment but increasing insider share ownership might lead to the expropriation of minority shareholders and increase overinvestment. Insider ownership might reduce underinvestment because of alignment of interests between managers and shareholders, but might also decrease the underinvestment problem due to the risk of default combined with the risk of declining share prices. In past research the relationship between cash flow and investment is also used to detect agency problems. Based on the outcomes of the literature eight hypotheses are developed. The sample consists of 68 Danish listed companies with 312 year-based observations. The research method used in this thesis is a mixed method research through a combination of quantitative and qualitative research. Data for the quantitative research is collected from annual reports. Data for the qualitative research is collected using semi-structured interviews with four financial managers of Danish listed companies. Quantitative analysis is performed in the form of a correlation analysis and a regression analysis to indicate whether and to what extent leverage and investment are related and whether the relationship can be explained by agency problems. Also the influence of share ownership on the relationship is examined using correlation analysis and regression analysis. Residual analysis is performed to analyze the magnitude of overinvestment and underinvestment and to analyze to what extent results found using correlation analysis and regression analysis hold. Qualitative analysis is performed to analyze whether the vision of managers on investment expenditure coincide with results found in the quantitative analysis. After testing the hypotheses results indicate that debt is related to investment with its direction and magnitude depending on sector and year. Overinvestment problems are found for the Industrials & Materials sector for the year 2007 when long-term debt is the leverage proxy. Interest-bearing debt seems to restrict overinvestment for the Health care sector and the Industrials & Materials sector for the years 2008, 2009 and 2010. Underinvestment problems are found in all sectors and all years when interest-bearing debt is the leverage proxy. Managerial share ownership does not influence the overinvestment problem. Managerial and institutional share ownership seem to reduce the underinvestment problem when ownership stakes are sufficiently large. The magnitude of the overinvestment and underinvestment problem are not severe, nor do they differ in magnitude. The result of the quantitative and qualitative analysis resemble, which indicates that the leverage-investment relationship is a feasible mechanism to detect agency problems. But the method has problems with isolating the effects of the agency problems. A relationship between leverage and investment does not necessarily indicate agency problems. Agency problems might also be influenced by different variables than debt, such as internal funding of projects, return on investment, law, and adjustment of the debt level in anticipation on future growth opportunities. Therefore additional research is required to determine which aspects influence investment expenditure and so the agency problems. These factors should be included in the agency theory, because the agency theory implies a relatively large role of debt in the agency problems while this might not be the case. Because quantitative research has difficulties in isolating the effects of overinvestment and underinvestment future research should combine both quantitative and qualitative analysis. Qualitative analysis could be conducted to gain insight in which aspects influence investment behavior so the quantitative analysis could be adjusted and defined to the aspects that influence investment behavior. Finally future research should focus on agency problems on the firm level instead of per sector because the presence and extent of agency problems might differ per firm.