Leverage and firm growth: The European evidences

Abstract

Abstract This thesis sets out to provide contribution to the on-going discussion of firm leverage and its effects on firm growth (measured in employment, capital expenditure growth and net investments) by applying similar methods as originated in Lang et al. (1996). However, this study presents additional insights dissimilar to existing research in three ways: 1) expand scope by including smaller firms with annual net sales less than $1 billion 2) verify US results in European setting and 3) explore deeper into the data set by introducing additional variables into the mix, such as firm size and legal systems to which the firms belong to.

A set of European data from 13 countries during 1990-2010 is used in this study. Firms included must have a SIC code between 2000 and 3999 (in order to minimize regulation effects) and at least $500 million annual sales in any given year in 1990 USD. The final data sample consists of 523 companies and around 5,000-6,000 firm-year observations depending on which one of the five growth measures are investigated: net investment, one and three-year employment growth rate and one and three-year capital expenditure growth rate. In addition to book leverage, the independent variable, sales growth, capital expenditures, cash flow and Tobin's q are added to the regression model as control variables.

The pooled European data of 13 countries shows that there is a comparable level of statistically significant negative correlation between book leverage and firm growth as the US results, only slightly stronger. There are also convincing evidence to the notion of stronger limiting effects of debt for firms with poor growth opportunities (approximated by low Tobin's q). However, in contrast to previous studies, no correlation is found between leverage and capital expenditure in this study.

In addition, the regression results shows partial support to the hypothesis of company size being inversely related to the severity of debt hindering growth. However, such effect is only limited to the smallest 30% of the firms in Europe concerning net investment but consistently so for all firms with 1-year employment growth measures.

With regards to legal systems, the negative correlation between book leverage and net investment is found to be the strongest in the French legal system, where it provides the least amount of investor protection. Hence results show some support for identifying legal system as a factor in leverage/debt dynamic but such conclusion is far from irrefutable.