Can the Changes in Capital Structure Due to Operating Profits Accumulate in the Long Term?

Abstract

It is well documented that once-lagged operating profits are negatively related with the firm’s current leverage ratio. This paper examine whether the changes in capital structure due to operating profits can accumulate in the long run. I find that the historical operating profits have economically and statistically significant long-term effects on capital structure, and that the weighted average historical profits over entire firm history have more explanatory power on current cross-sectional capital structure variations than the well accepted four once-lagged leverage determinants all together do. The findings in this paper show that the current capital structure is, to a large extent, the cumulative outcome of historical operating profits.

Keywords: Capital Structure, Corporate Finance