Leverage and firm investment: the role of information asymmetry and growth

• DOI: https://doi.org/10.1108/IJAIM-10-2017-0127
• Pages: 56-73
• Published date: 04 March 2019
• Date: 04 March 2019
• Author: Albert Danso,Theophilus Lartey,Samuel Fosu,Samuel Owusu-Agyei,Moshfique Uddin
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Leverage and firm investment: the

role of information asymmetry

and growth

Albert Danso and Theophilus Lartey

Leicester Castle Business School, De Montfort University, Leicester, UK

Samuel Fosu

Business School, University of Birmingham, Birmingham, UK

Samuel Owusu-Agyei

Leicester Castle Business School, De Montfort University, Leicester UK, and

Moshfique Uddin

Business School, Leeds University, Leeds, UK

Abstract

Purpose –This paper aims to demonstratehow financial leverage impacts firm investment and the extent

to which this relationshipis conditional on the level of information asymmetryas well as growth.

Design/methodology/approach –The paper relies on data from 2,403 Indian firms during the period

1995-2014, generatinga total of 19,544 firm-year observations.Analysis is conducted by using various panel

econometrictechniques.

Findings –Drawing insightsfrom agency theories, the paper uncovers that financial leverage is negatively

and significantly related tofirm investment. It is also observed that the impact of financialleverage on firm

investment is significant for high information asymmetric firms. Finally, the paper shows that the

relationship between leverage and firm investment is significant for low-growth firms. However, no

significantrelationship is found between leverageand investment for high-growth firms.

Originality/value –This paper provides fresh evidence on the leverage–investment nexus and, to the

authors’knowledge,it the first paper to examine the extent to which this leverage–investmentrelationship is

driven by the level of informationasymmetry.

Keywords India, Leverage, Information asymmetry, Investment

Paper type Research paper

1. Introduction

This paper provides a new contribution to the existingliterature by examining the effect of

firm leverage on investment with a specific focus on Indian firms. It also distinctively

examines the extent to which the leverage–investment relationship is driven by the levelof

information asymmetry as well as firm growth. The analysesare conducted and the results

interpreted withina classic agency theoretical framework.

The central proposition of Modiglianiand Miller’s (1958) (hereafter MM) seminal work is

that, under the assumption of perfect capital markets, capital structure is irrelevant to firm

value and hence a firm’sfinancing and investment decisions are independent. This means

JEL classification –G14, G30, G31, G32

IJAIM

27,1

56

Received26 October 2017

Revised13 November 2017

Accepted23 November 2017

InternationalJournal of

Accounting& Information

Management

Vol.27 No. 1, 2019

pp. 56-73

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-10-2017-0127

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

that firm managers could not maximise the value of their firms by altering the debt-equity

mix. Thus, in the view of Modigliani and Miller (1958),afirm with profitable investment

opportunities could still obtain the external funds required regardless of the state of its

financial position. Subsequent developments, however, suggest that a firm’s capital

structure is essentially relevant as finance affects real investment decisions. For instance,

Myers (1977) shows that firms with more debt service are likely to have their positive net

present value (NPV) projects go unfunded because of the issue of debt overhang created by

prior debt financing. Consequently,this suggests that the leverage level of a firm matters in

its investment decision. In respect of this, a significant number of studies (Bradley et al.,

1984;Friend and Lang, 1988;Denis and Denis, 1993;McConnell and Servaes, 1995;Lang

et al.,1996;Aivazian et al., 2005a;Cleary, 2006) have been devoted to examining the

leverage-investment relationship. However, these empirical studies are heavily biased to

data originating in developed nation settings, ignoring potential variations in the

investment outcome of financial leveragein firms located in less developed markets. Given

this gap, it is therefore important to probe the leverage-investment relationship in the

context of an emerging marketsuch as India. Thus, by relying on large-scale data from over

2,400 firms, this study offers a freshinsight into the leverage–investment relationship from

the context of an emerging economy –India. Our work is closely related in spirit, though

distinct from prior studies (Aivazian et al., 2005b;Ahn et al., 2006) in one major respect: we

argue on the basis of prior scholarly works (Lang et al., 1996) that management chooses

leverage based on its private information about the firm’s future growth opportunities.

Thus, as a way of extension, the paper assesses the extentto which the leverage–investment

relationship is conditional on the level of information asymmetry. Consistent with other

empirical works (Lang et al.,1996;Aivazian et al., 2005b;Ahn et al., 2006), the results

indicate that leverage is negativelyrelated to firm investment and significantly stronger for

high information asymmetricfirms. Moreover, it is observed that this negative effect is also

significantly strongerfor low-growth firms than for high-growth firms.

The paper contributes to the financeliterature in the following ways. First, by relying on

data from India, it is among the first to examine the leverage–investment nexus outside the

context of a developed market. By so doing, it demonstrates that the leverage–investment

relationship evidentin the developed context is also applicable in the context of an emerging

market. Second, despite the burgeoning managerial and academic interest in capital

structure issues, scholarly research is yet to examine if information asymmetry drives the

leverage–investment relationship. Given this, the paper extends extant knowledge on the

financial leverage–investment relationship by showing how the relationship is shaped by

degrees of information asymmetry. By relying on analysts’forecast properties, the paper

demonstrates that leverage is negatively related to investment and that this negative effect

is significantly stronger for high information asymmetric firms. To the best of the authors’

knowledge, this is the firststudy to examine this.

The rest of the paper is organised as follows:Section 2 provides a brief background of the

study; Section 3 examines relevant literature and its theoretical underpinnings; Section 4

discusses the sample,empirical design and measurement of variables; Section5 presents the

regression results and discussion;finally, Section 6 provides a summary of the findings and

concludes the study.

2. Background of study

An overview of the unique features of India’seconomic, financial and investment structure

puts this paper into perspective. In India, there has been continuously rapid economic

growth over the past three decades, for instance,the institutionalisation of the 1991 financial

Leverage and

firm

investment

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