Leasing and Debt Financing : Substitutes or Complements?

Most finance theories suggest that debt and leases are substitutes. However, the empirical findings on the substitutability between leases and debt are mixed. This paper empirically re-investigates this relationship, and differs from the previous literature in three aspects. First we construct a simple structural model in which the substitutability/complementarity between debt and leases is related to their joint financing cost function. Second, we utilize a generalized method of moments (GMM) technique in our econometric estimation to simultaneously control the endogeneity problem and the firms' fixed effects. The results using this technique show that leases and debt are substitutes instead of complements. Third, we investigate the impact of asymmetric information, agency costs, and taxes on the substitutability between debt and leases. We find that debt and leases are more likely to be used as substitutes in those firms facing more severe asymmetric information problems or agency problems, or in those firms having less redundant tax shields