Financial Leverage and Total Factor Productivity Growth : Firm-level Evidence from India

This study examines the relationship between firm leverage and total factor productivity for a large panel of manufacturing firms in India over the period: 2000-2015. Using the debt-ratio as a measure of firm leverage, the results indicate that there exists a negative relationship between leverage and firm productivity, which is statistically and economically significant and robust to alternative definitions of productivity. This negative association remains significant even after accounting for the potential endogeneity of leverage using a two-stage least squares instrumental variable (IV) approach. This finding is consistent with theoretical predictions which suggest that the agency costs of debt may induce sub-optimal investment. I assess the role of a potential source of firm heterogeneity by examining whether the observed effect is contingent on firm size. The results suggest that higher leverage is associated with declines in productivity (or investments in productivity-enhancing activities) of a greater magnitude for the larger manufacturing firms. In the final step, I examine the relationship between leverage and various measures of firm value. The results indicate that the agency costs of debt are a significant factor associated with lower firm-level investment and return on assets