Profitability, Mean Reversion of Leverage Ratios, and Capital Structure Choices

Abstract

We seek economic interpretations for two well-known empirical regularities. First, it is well known that more profitable firms tend to have lower leverage ratios, a pattern driven by the preference on internal funds by these profitable firms. Some recent theoretical development has used transaction costs or dynamic tax considerations to explain this phenomenon. We show that the phenomenon largely remains even after these factors are controlled for. Second, through both theoretical and empirical illustrations, we show that leverage ratios can revert to mean mechanically regardless of which theory better describes financial decisions; and that opposite inferences can be drawn depending on whether financing decisions or leverage ratio changes are studies. Therefore, leverage ratio changes might not be informative in distinguishing the competing theories. Our finding cautions against the common practice of relying on the dynamics of leverage ratio changes to draw conclusions on the validity of capital structure theories.