Variance of Firm Performance and Leverage of Small Businesses

We investigate the relationship between leverage and firm performance using small business data from Japan by estimating the effects of leverage on both average firm performance and the variance of firm performance. We find that leverage has a negative effect on average firm performance and a positive effect on the variance of firm performance. This suggests that the problem of moral hazard is severe for highly leveraged firms. However, when highly leveraged firms have sufficient collateral assets, the effects of leverage are positive for average performance, but negative for the variance of performance. This implies that when small firms have sufficient collateral assets, highly leveraged businesses are better performers.