Firm Profitability, Inventory Volatility, and Capital Structure

37 Pages Posted: 23 Aug 2011  

John R. Birge

University of Chicago - Booth School of Business

Xiaodong Xu

Northwestern University - Department of Industrial Engineering and Management Sciences

Date Written: August 23, 2011

Abstract

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

Birge, John R. and Xu, Xiaodong, Firm Profitability, Inventory Volatility, and Capital Structure (August 23, 2011). Available at SSRN: https://ssrn.com/abstract=1914690 or http://dx.doi.org/10.2139/ssrn.1914690

John R. Birge (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Xiaodong Xu

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

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