The Profits-Leverage Puzzle Revisited

53 Pages Posted: 17 Jun 2011 Last revised: 23 Jul 2014

See all articles by Murray Z. Frank

Murray Z. Frank

University of Minnesota

Vidhan K. Goyal

Hong Kong University of Science & Technology (HKUST) - Department of Finance

Date Written: June 27, 2014

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 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

Frank, Murray Z. and Goyal, Vidhan K., The Profits-Leverage Puzzle Revisited (June 27, 2014). Available at SSRN: https://ssrn.com/abstract=1863629 or http://dx.doi.org/10.2139/ssrn.1863629

Murray Z. Frank

University of Minnesota ( email )

Carlson School of Management
321 19th Avenue South
Minneapolis, MN 55455
United States
612-625-5678 (Phone)

Vidhan K. Goyal (Contact Author)

Hong Kong University of Science & Technology (HKUST) - Department of Finance ( email )

Clear Water Bay, Kowloon
Hong Kong
852-2358-7678 (Phone)
852-2358-1749 (Fax)

HOME PAGE: http://www.vidhangoyal.com

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