Cost of Debt and Corporate Profitability

Pierluigi Santosuosso

doi:10.5539/ibr.v7n2p13

Abstract

This paper examines the relationship between the cost of debt and corporate profitability using a sample of 3,556 Italian unlisted firms between 2007 and 2011. On the basis of the logistic regression model, we find that the cost of debt, measured by the interest expense to financial debt ratio, is negatively correlated to various proxies of firm profitability. These findings are consistent with previous research on the relevance of indirect costs of corporate distress. However, although the analysis found evidence that unprofitable firms are highly leveraged in accordance with the Pecking order theory, we also observed that the cost of debt for the firms included in the sample is inversely dependent on the amount of financial debt.

Highlights

The world economic crisis, characterized by a severe financing constraints such as the slowdown in bank lending and stock market volatility, has not diminished the need for analyzing capital structure related issues
We will examine the relationship between the cost of debt, measured by the interest expense to financial debt ratio, and various proxies of firm profitability using a sample of 3,556 Italian unlisted firms between 2007 and 2011
According to the well-known Pecking order theory (POT), capital structure decisions lead to a negative correlation between profitability and leverage so that firms with low profitability have a degree of leverage greater than firms with high profitability

Summary

Introduction

The world economic crisis, characterized by a severe financing constraints such as the slowdown in bank lending and stock market volatility, has not diminished the need for analyzing capital structure related issues. Since 1958, when Modigliani and Miller suggested the irrelevance of financial policy, several studies have stressed that the cost of bankruptcy may offset the benefit arising from the tax deductibility of interest In this debate, the direct and indirect costs of bankruptcy and corporate distress have been widely investigated in the research literature in order to assess the costs and benefits of debt financing. The first hypothesis we attempt to verify is the existence of an inverse relationship between the cost of debt and firm profitability This question is related to another central issue of corporate finance. It is likely that such a level of leverage might contribute to a further increase in the cost of debt because of the rising risk of distress that could derive from a high level of debt financing Given this scenario, the second hypothesis we tested is whether the cost of debt is positively correlated to some proxies of firm leverage

Objectives

Results

Conclusion