Debt, incentives and performance:evidence from UK panel data

A large body of theoretical literature suggests that capital structure plays an important role as a managerial incentive mechanism. Cross-sectional empirical studies have identified a positive effect of leverage on expected performance (measured by Q) for firms with low growth opportunities: this has been interpreted as supporting Jensen's free cash flow hypothesis. However, this evidence does not take into account the endogeneity of capital structure decisions. We investigate how endogeneity affects the results using instrumental variables and allowing for dynamics. The results of earlier studies are then re-interpreted in the light of our findings.