Profits and Capital Structure
42 Pages Posted: 13 Mar 2008 Last revised: 30 Jul 2014
Date Written: March 11, 2008
In the static trade-off theory, when profits increase, the firm should issue more debt and reduce equity to shield the profits from taxation or agency abuse. When a corporate leverage ratio is explained by firm profits, it is well-known that a negative regression coefficient is usually found. The literature (e.g., Myers (1993), Fama and French (2002), and Welch (2007)) considers this negative relationship to be a particularly serious rejection of the static trade-off theory.
In this paper, we show that the literature has misinterpreted the evidence as a result of the wide-spread use of familiar, but inappropriate, empirical methods. We make four main points.
1. We show that highly profitable firms do actually tend to issue debt and repurchase equity. The least profitable firms tend to reduce debt and issue equity. These facts are empirically very robust.
2. Firm size plays an important mediating role in this relationship that gets hidden when leverage ratios are used. Large firms tend to be more active in the public debt markets, while small firms tend to be relatively more active in the equity markets.
3. The type of empirical work that is appropriate depends on the model to be tested. We present a simple static trade-off agency-based model of capital structure. According to the model, the appropriate testing structure is a pair of regressions: one explaining debt, and the other explaining equity. When we estimate this model, we find the model's predictions perform rather well. Profits are not properly exogenous according to the model. We discuss how to deal with the exogeneity problem within the context of the model.
4. In the model, issuing decisions depend on market conditions ('market timing'). Empirically, bad market conditions have a particularly strong impact on small and low-profit firms. Larger and more profitable firms are less strongly affected by market conditions.
Contrary to what is usually believed, the empirical evidence on profits and capital structure seems easy to interpret from the perspective of the static trade-off theory.
Keywords: Capital structure, Trade-off theory, Profits, Agency theory, Leverage ratios
JEL Classification: G32
Suggested Citation: Suggested Citation