Abstract
Abstract The inverse relation between leverage and profitability is widely regarded as a serious defect of the trade-off theory. We show that the defect is not with the theory but with the use of a leverage ratio in which profitability affects both the numerator and the denominator. Profitability directly increases the value of equity. Firms do take the predicted offsetting actions. They issue debt and repurchase equity when profitability rises, and retire debt and issue equity when profitability falls. Consistent with variable transactions costs, the adjustment is not generally sufficient to fully undo the profitability shocks. Accordingly, on average the leverage ratio falls as profitability rises.
Highlights
The trade-off theory of capital structure predicts that more profitable firms ought to borrow more and have higher leverage
The empirical methodology has focused on leverage ratios, but interpreted them as if they were the result of debt market actions
Since we employ the usual data, it is not surprising that our results match those reported in the existing capital structure literature, i.e., profitability has a negative sign in both the book leverage regression and in the market leverage regression
Summary
The trade-off theory of capital structure predicts that more profitable firms ought to borrow more and have higher leverage. The profits-leverage puzzle is the empirical evidence that the predicted sign is backwards. The trade-off theory of capital structure predicts that more profitable firms ought to borrow more and have higher leverage.. The most profitable firms borrow less, the least profitable borrow more” (Myers, 1993, page 6) This relationship between corporate profits and leverage is widely regarded as a serious defect of the trade-off theory The empirical methodology has focused on leverage ratios, but interpreted them as if they were the result of debt market actions. This rejection could arise if the trade-off theory is wrong. The lowest profit firms tend to retire debt and raise more equity capital These basic patterns are very much in line with the traditional interpretation of the static trade-off theory, but contradict the profits-leverage puzzle. More profitable firms will automatically have more book equity and more market equity, unless the firm takes offsetting actions
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