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CapitalStructureandFirmPerformance1.IntroductionAgencycostsrepresentimportantproblemsincorporategovernanceinbothfinanciahndnonfinancialindustries.Theseparationofownershipandcontrolinaprofessionallymanagedfirresultinmanagersexertinginsufficientworkeffort,indulginginperquisites,choosinginputsthatsuittheirownpreferences,orotherwisefailingtomaximizefirmvalue.Ineffect,theageofoutsideownershipequalthelostvaluefromprofessionanlanagersmaximizingtheiiownutility,ratherthanthevalueofthefirm.Theorysuggeststhatthechoiceofcapitalstructuremayhelptheseagencycosts.Undertheagencycostshypothesis,highleverageoralowequity/assetratiotheagencycostsofoutsideequityandincreasesfirmvaluebyconstrainingorencouragingmanagactmoreintheinterestsofshareholders.SincetheseminalpaperbyJensenandMeckling(1976)literatureonsuchagency-theoreticexplanationsofcapitalstructurehasdeveloped(seeHarrisa1991andMyers21forreviews).Greaterfinancialleveragemayaffectmanagersandreduceagercoststhroughthethreatofliquidation,whichcausespersonallossestomanagersofsalaries,rperquisites,etc,(e.g.,GrossmanandHart1982,Williams1987),andthroughpressuretogeneratflowtopayinterestxpenses(e.g.Jensen1986).Higherleveragecanmitigat田onflictketweenshareholdersandmanagersconcerningthechoiceofinvestment(e.g.,Mlyeramoun7)ofrisktoundertake(e.g.,JensenandMeckling1976,Williams1987),theconditionsunderwhichthefiliquidated(e.g.,HarrisandRaviv1990),anddividendpolicy(e.g.,Stulz1990).Atestablepredictionofthisclassofmodelsisthatincreasingtheleverageratioshouldloweragencycostsofoutsideequityandimprovedfirmperformance,allelseheldequal.However,whenleveragebecomerelativehjigh,furtheiincreasegeneratesignificaagencycostsofoutsidedebtincludingiigherexpectedcostsofbankruptcyorfinancialistressarisinfromconflictsbetweenbondholdersandshareholders.1Becauseitisdifficulttodistinguishempiricallybetwetwosourcesofagencycosts,wefollowtheliteratureandallowtherelationshipbetweentotalcostsandleveragetobenonmonotonic.Despitetheimportanceofthistheory,thereisatbestmixedem
