Firm Profitability, Inventory Volatility, and Capital Structure
37 Pages Posted: 23 Aug 2011
Date Written: August 23, 2011
Traditional theories of capital structure imply a consistent relationship between firm profitability and firm leverage. Empirical data, however, suggest that the relationship is not monotonic. In the cross-section of firms, non-profitable firms become significantly more leveraged as losses decrease; profitable firms become significantly less leveraged as profits increase until a point where the most profitable firms have again significantly greater leverage as profits increase. In this paper, we present an extension of a model of Xu and Birge (2004) that is consistent with these observations. The model assumes that firms make debt and production scale decisions that depend on fixed costs necessary to maintain operations, variable costs of production, and volatility in future demand forecasts. In addition to predicting the convex relationship between profit margins and leverage that appears in the data, the model also predicts decreasing inventory volatility for non-profitable firms followed by increasing inventory volatility for profitable firms, which is also a statistically significant result in the data. These observations are consistent with a model of firms that make early price and quantity commitments in advance of demand realization as in the classical news vendor model of operations.
Keywords: Production and capacity decisions, Capital structure
JEL Classification: C61, G31, G32
Suggested Citation: Suggested Citation