The Leverage-Profitability Puzzle Revisited with Costly Rebalancing
43 Pages Posted: 24 Apr 2018 Last revised: 9 Jul 2020
Date Written: July 8, 2020
The `leverage-profitability puzzle' refers to the persistent inverse relation between profitability and leverage observed for US industrial companies, which contradicts capital structure tradeoff theory with exogenous investment. 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 new debt issues. The conditional relation is positive only when the distribution is financed internally by drawing down cash-balances. This evidence 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