DOES LEVERAGE MEDIATE THE ROLE OF REINVESTMENTS IN ENHANCING FIRM PERFORMANCE? EMPIRICAL EVIDENCE FROM DEVELOPED ECONOMIES

Abstract

This study attempts to reestablish at the explanatory power of the pecking order theory of optimal capital structure in the context of developed countries. This way it makes some extensions to empirical work on pecking order theory. It looks at those aspects of pecking order theory, which has not been empirically examined before. Like, an argument could be established that if it is true that internal funds are necessary to utilize first before hiring finances from debts and equity, then is it also true that by using internal funds the firms can get rid of debts and equity gradually? Panel data methodology was used to conduct the study for a sample of 110 firms from developed countries like Australia, New Zealand, Japan, and Hong Kong during 2015 to 2023. The study employs reinvestment (independent variable), the debt ratio and the debt-to-equity ratio (mediator), and return on assets as a performance metric (dependent variable), and one control variable is size (natural log of total assets). The results demonstrate that financial leverage acted as a mediator in the relationship between reinvestment and business performance. However, this partial mediation and performance level of the firm can be enhanced by lowering the external financing level in the firm's capital structure. The results of the study show that if a firm reinvests its internal funds rather than hiring capital from debts (external resources), then low leverage enhances firm performance by lowering the heavy cost of capital (cost of debts and equity). This study outlines a financial framework for organizations in developing countries, illustrating how they emulate the practices of developed countries and can establish their standards based on those practices. It also includes that, by employing finances from internal funds and by lowering the external finances, the organizations become free from the heavy cost of external financing that enhances firm performance.