This paper is an attempt to look into the issue of the effect of leverage and adjustment costs on various measures of corporate performance for three hundreds and seventy four non-financial firms listed on Karachi Stock Exchange of Pakistan. This study covered only Pakistan equity market. A panel data set spanning 1988 to 2008 is used for the purpose. The Arellano and Bond dynamic panel data estimation technique (a variant of GMM) is used to capture the role of adjustment costs and the dynamic behavior of corporate performance. The results, thus obtained, are essentially mixed. The coefficients of the adjustment variable (lagged corporate performance) are positive for ROCE (Return on capital employed) and EPS (Earnings per Share) but ironically negative for ROE (Return on Equity). Similarly the effect of leverage on ROCE is negative but insignificant and positive significant when EPS is used as a measure of corporate performance. Whereas the relationship between leverage and ROE (another measure used in the paper for corporate performance) is negative and significant which implies that high leverage force the managers to perform optimally due to higher interest burden and agency cost. The negative effect of leverage is consistent with dynamic picking order theory that increase in debt reduce firms value by reducing its safe debt capacity and causes underinvestment in the long run. The positive effect of the size of a firm on performance is confirmed for all the three measures of corporate
performance. Furthermore, the positive and statistically significant impact of short term liabilities implies that high short term liabilities exert pressure on corporate managers to perform efficiently in the competitive market. In Pakistan equity market the leverage overall impact on corporate performance was positive indicating that firms can increase profits through debt financing instead of equity financing. The current study was among the few that used The Arellano and Bond dynamic panel data estimation technique (a variant of GMM) to investigate corporate performance.
Keywords: Corporate Performance, Leverage, adjustment costs, Panel Data