Debt's shadow: How leverage weighs down investment

Abstract

Investment and financial leverage are critical determinants of firm growth and central topics in corporate finance literature. While extensive research has explored the leverage-investment relationship in developed and large transitional economies, limited attention has been paid to smaller, bank-based economies like South Korea. This study examines how financial leverage influences the investment behavior of Korean firms, analyzing a comprehensive sample of 25,437 listed and non-listed firms from 2010 to 2019. Using firm fixed-effects regressions and an instrumental variable approach to address endogeneity, we find a robust negative relationship between leverage and investment. This relationship is more pronounced in manufacturing and larger firms, but weaker in firms with high growth opportunities, high cash flow, and high leverage. Our findings suggest that leverage can discipline managers by mitigating overinvestment tendencies, and high leverage also risks deterring investment in positive NPV projects due to debt overhangs, supporting predictions from theories of information asymmetry and agency conflicts.

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