Profitability and financial leverage: Evidence from a quasi-natural experiment

Abstract

The relationship between profitability and leverage has been controversial in the capital structure literature. We revisit this relation in light of a novel quasi-natural experiment that increases market power for a subset of firms. We find that treated firms increase their profitability throughout the treatment period. However, they only transiently reduce financial leverage, gradually reverting to their pre-shock level. Firms respond differently according to size, with large firms gradually adjusting their leverage towards a new target and small firms reducing it. The patterns are broadly consistent with dynamic trade-off models with both fixed and variable adjustment costs.

Keywords: profits-leverage puzzle, trademarks, product markets, capital structure, customer-supplier relations, market power

JEL Classification: G32, L10