Growth options effect on leverage: Evidence from China

• The growth options reduce corporate leverage in China in a highly convex manner.
• EXP{− MB ratio} is a better proxy for growth options than MB ratio.
• The growth options effect on leverage is stronger in firms characterized by wider insider control-ownership divergence.
• The growth options effect on leverage is stronger in firms that face more severe financial constraints.

Using the market-to-book assets (MB) ratio and its inverse exponential transformation as proxies for growth options, we find that the growth options effect on leverage is negative and highly convex in China, consistent with the U.S. evidence from Ogden and Wu (2013). Of particular importance, using a nonlinear transformed rather than a linear MB ratio yields stronger explanatory power for the growth options effect on leverage in tests of both static and dynamic trade-off theories. Moreover, we show that the growth options effect on leverage is stronger among firms characterized by wider divergence between control rights and cash-flow rights of the largest ultimate owner and firms that face more severe financial constraints.