Microsoft Word 2007 ichrie conference Proceedings Final-Final 06-06-07. doc

Capital structure and performance 
Among conventional capital structure theories, the agency cost theory is the most popular explanation for 
the influence of leverage decision on financial performance (Jensen, 1986). The agency cost theory suggests that 
financial leverage could improve financial performance because of its disciplinary effect on manager behavior. 
Agency costs occur when manager self interests do not align with those of shareholders. To preserve personal 
financial security, managers whose fortune is closely tied to the company through substantial insider ownership may 
tend to forgo risky ventures even if they are value-added. Moreover, managers may also use free cash flow for 
“empire building” or corporate perks instead of investing in value creating projects. Through debt creation, 
managers are contractually bound to service the debt obligation. Failing to fulfill the obligation results in insolvency; 
managers would also lose personal fortunes. Therefore, higher leverage would push managers to pursue true value-
enhance ventures in order to avoid personal losses (Simerly & Li, 2000). In short, financial leverage functions as a 
corporate governance tool to improve profitability. The risk shifting nature of debt financing provides another 
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Following Markides and Williamson’s (1994) definition, strategic assets are those “underpin a firm’s cost or 
differentiation advantage in a particular market and that are imperfectly imitable, imperfectly substitutable and 
imperfectly tradeable.” And core competences are defined as “the pool of experience, knowledge and system, etc. 
that exist elsewhere in the same corporation and can be deployed to reduce that cost or time required either to create 
a new strategic asset or expand the stock of an existing one.” 

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