The Profits-Leverage Puzzle Revisited
53 Pages Posted: 17 Jun 2011 Last revised: 23 Jul 2014
Date Written: June 27, 2014
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 retire debt and issue equity 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.
Keywords: Capital structure, Trade-off theory, Profits, Agency theory, Leverage ratios
JEL Classification: G32
Suggested Citation: Suggested Citation