The Profits-Leverage Puzzle Revisited

Abstract:     
The inverse relation between leverage and profitability is widely regarded as a serious defect of the tradeoff 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 doing the reverse when profitability falls. Consistent with variable transactions costs, the adjustment is not sufficient to fully undo the impact. Accordingly the leverage ratio falls as profitability rises.

Number of Pages in PDF File: 43

Keywords: Capital structure, Trade-off theory, Profits, Agency theory, Leverage ratios

JEL Classification: G32

working papers series