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The Agency Advantage, of Debt Over the Lifecycle of the Firm Ed VOZ Carolyn FORLONG University of Waikato Department of Finance Private bag 3105 Hamilton, NEW ZEALAND Phone: (64) 7 856-2889 Fax: (64) 7 838 4145 Abstract The question of an 'optimal' capital structure of a firm has been studied for publicly listed businesses. Agency theory has emerged as a good way to explain why firms picktheir capital structure. This paper empirically examines the role that agency theory plays in determining the movement of businesses as they move from being small unlisted businesses to newly listed on the stock exchange, to being mature listed businesses. The paper finds that debt has a negative agency advantage (defined as reducing agency costs of equity) for small businesses, a significant butminor advantage at the IPO stage, and a significant advantage at the mature listed stage. INTRODUCTION Managers often spend much effort determining the optimal level of debt for their particular firm. This task is made more difficult when market and firm factors cause a firm's optimal debt level to vary. Many studies have empirically tested the significance of debt for listed firms, but few haveexamined the role of debt at different stages of a firm's life cycle. The purpose of this study is to empirically test the agency advantage of debt over the life cycle of the business. The agency advantage of debt is interpreted as the degree that debt benefits the firm by reducing the agency costs of equity. It is expected that the changing market imperfections and ownership structures over thefirm life cycle will cause the role of leverage to shift also. The firm life cycle has been divided into three stages: the small business, initial public offering (IPO), and mature-listed stage. Small businesses are defined as unlisted businesses where the owner is also the manager of the firm. IPO firms are those which have listed on the stock exchange in the past year and mature-listed

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firms are those which have listed on the stock exchange for five or more years. Before testing the agency advantage of debt at the three stages, the current financial literature is reviewed. Capital structure theories and the characteristics of the small businesses and IPO firms are discussed, and are useful in understanding of the role of debt. The paper then reports on empirical testsof leverage in four data sets and comes to a conclusion about the role of debt at each business stage. Agency advantage of debt: the degree that debt benefits the firm by reducing the agency costs of equity. 2 LITERATURE REVIEW 2.1 Capital Structure Theory

There are four generally accepted theories which explain the significance of debt in presence taxes, bankruptcy costs, asymmetricalinformation, and agency costs. Firstly, there is evidence that debt, through interest payments, creates a tax shield advantage which is balanced by the cost of bankruptcy. This theory is supported by Givoly et al. (1992) who documented a positive association between the debt ratio and changes in tax rates. The pecking order hypothesis as introduced by Myers and Majluf (1984) suggests that asymmetricalinformation leads to a financial hierarchy of preferred financing. Myers and Majluf argue that managers will issue the least risky security available in order to reduce costs when new debt or equity is underpriced by uninformed investors. Agency theory focuses on the separation between management and ownership which can lead to conflict between managers, bond holders, and owners. The theory is basedon the idea that managers will not always act in the best interests of the investors. For instance, managers may seek to consume "perquisites" and decrease their work load if the cost of doing so is mainly absorbed by the investor. Consequently, agency costs consist of the monitoring, bonding and auditing of managerial performance by both debt holders and shareholders. It is argued that debt...
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