Corporate Capital Structure and Product Quality

Abstract: Maksimovic and Titman (1991)'s model on the stakeholder theory of capital structure suggests that firms commit to providing high quality products by means of a low debt-to- equity ratio. I empirically test this theoretical prediction by examining the effect that product quality has on a firm's leverage. I use US firm level data on product quality ratings from the KLD STATS database as well as financial information regarding debt-to-equity ratios from Compustat between 2003 and 2009. Using a pooled ordinary least squares, an industry fixed effects, as well as a firm fixed effects regression estimation of the partial adjustment model of leverage, this study can confirm that firms that offer products with high quality choose low leverage ratios as predicted by Maksimovic and Titman (1991). Nevertheless, this result is not robust to controlling for firm size and other standard control variables for leverage. A potential explanation is that firms which are small in size provide high product quality, but the choice of leverage ratio of these firms originates rather in firm size. Thus, I conclude that product quality per se does not have an effect on leverage for my sample of firms and reject Maksimovic and Titman (1991)'s model on the stakeholder theory of capital structure on the basis of this analysis.