Are Firms Underleveraged? An Examination of the Effect of Leverage on Default Probabilities

A commonly held view in corporate finance is that firms are less leveraged than they should be, given the potentially large tax benefits of debt. In this paper, I study the effect of firms' leverage on default probabilities as represented by the firms' ratings. Using an instrumental variable approach, I find that the leverage's effect on ratings is three times stronger than it is if the endogeneity of leverage is ignored. This stronger effect results in a higher impact of leverage on the ex ante costs of financial distress, which can offset the current estimates of the tax benefits of debt. Copyright 2005 by The American Finance Association.