Operating Inflexibility, Profitability and Capital Structure

Abstract

Operating leverage crowds-out financial leverage while also increasing profitability. Thus, operating leverage generates the negative relation between profitability and financial leverage that appears to be inconsistent with the trade-off theory, but is commonly observed in the data. We find empirically that, by removing the effect of operating leverage from profitability, the negative association between the profitability and financial leverage decreases by about 70%, confirming the channel. We demonstrate the effect of operating leverage on firms’ financial leverage decisions during the financial crisis.