An agency theory approach to financial leasing

Theoretical works on financial leasing generally assume perfect market conditions and show that the only rationale for capital leases, which are considered substitutes for borrowing, is the tax differential between the lessee and the lessor. Empirical studies, however, show that lessors invariably earn returns higher than lenders. Also, studies of lessees have shown that lease ratios and debt ratios are positively correlated, indicating that debt_and lease financing may be complements rather than substitutes. There have been no explanations for these puzzling results. This dissertation departs from the analytical approach to financial leasing found in extant literature by explicitly recognizing the existence of agency costs and bankruptcy costs. It is shown that leasing has lower agency and bankruptcy costs. Therefore, firms with high agency costs of debt and high bankruptcy potential may find it attractive to lease even in the absence of a tax incentive. The dissertation develops empirically testable hypotheses, which are tested as part of the dissertation.

The empirical analysis uses a large sample of firms from the Disclosure database. The firms are classified into leasing and non-leasing firms, using the criterion of the presence of capitalized leases in the balance sheet. The basic hypotheses tested are as follows:

1. The leasing firms and non-leasing firms differ in many financial characteristics.
2. The leasing firms have higher bankruptcy potential.
3. The leasing firms have higher agency costs of debt. The study uses univariate analysis for testing differences in mean values for a number of accounting and financial ratios which are considered proxies for bankruptcy potential and agency costs of debt. Multivariate methods like regression and discriminant analysis are also used to provide additional and confirmatory evidence.

The evidence reveals general support for the theory developed in the dissertation. There are significant differences in several financial ratios for the leasing and non-leasing firms. The leasing firms use higher leverage and show higher growth rates for sales, earnings before interest and taxes, and fixed assets. The leasing firms also show higher business risk as measured by the coefficient of variation of earnings before interest and taxes.