Non-linearity in debt and return relationship: evidence from dynamic panel threshold method

• Main Authors: Matemilola, Bolaji Tunde, Amin Noordin, Bany Ariffin, Wan Ngah, Wan Azman Saini, Md Nasir, Annuar
• Format: Article
• Language: English
• Published: Asian Network for Scientific Information 2016
• Online Access: http://psasir.upm.edu.my/id/eprint/53393/1/Non-linearity%20in%20debt%20and%20return%20relationship.pdf; http://psasir.upm.edu.my/id/eprint/53393/; http://scialert.net/abstract/?doi=jas.2016.438.444
• Institution: Universiti Putra Malaysia

Background and objective: Moderate debt usage increases returns during economic boom, but high debt could decreases returns during economic recession. This study examines if there is a threshold debt level in the debt-returns relationship. Methodology: This study applies dynamic panel-threshold method to determine optimal debt level beyond which further increases in debt decreases returns. This study finds a threshold effect of 20.570% between debt ratio and return on equity. If the debt ratio is lower than 20.570%, a 1% increases in debt ratio increase return on equity by 0.128%. But, when the debt ratio is higher than 20.570%, a 1% increase in debt ratio decreases return on equity by 0.050%. Results: The results suggest that there is an optimal debt ratio of 20.570% at which point further increase in debt decreases return on equity. Conclusion: These results support the tradeoff theory, which suggests that there is an optimum debt level that maximizes returns.