Abstract
An important and robust finding in the capital structure literature is the inverse relation between profitability and leverage. We revisit this relation in light of a novel quasi-natural experiment that increases market power for a subset of firms and has spillovers on their suppliers. We find that treated firms and their suppliers similarly increase their profitability, but only suppliers reduce their leverage in response. The different nature of profitability shocks explains the results: The profitability increase was permanent and riskless for treated firms, but transitory and risky for suppliers. Unobserved components of profitability variation seem to explain earlier findings.
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