The Leverage-Profitability Puzzle Revisited
44 Pages Posted: 24 Apr 2018 Last revised: 6 Sep 2019
Date Written: September 6, 2019
The `leverage-profitability puzzle' refers to the inverse unconditional relation between profitability and leverage observed for US industrial companies. Recent research suggests that the relation may be conditionally positive - in periods when firms actively rebalance leverage by distributing cash to shareholders - and negative in other periods. However, we show that the relation is conditionally negative when the shareholder distribution is financed with debt issues. The conditional relation is positive only if the distribution is financed internally by drawing down cash-balances. This evidence, which contradicts `dynamic inactivity' (tradeoff) theory with costly external finance, effectively resurrects the original leverage-profitability puzzle.
Keywords: Capital structure, tradeoff theory, dynamic inaction, recapitalizations, leverage-profitbility correlation, pecking order
JEL Classification: G32
Suggested Citation: Suggested Citation