The leverage-profitability puzzle ressurected

43 Pages Posted: 24 Apr 2018 Last revised: 20 Oct 2020

See all articles by B. Espen Eckbo

B. Espen Eckbo

Tuck School of Business at Dartmouth; European Corporate Governance Institute (ECGI)

Michael Kisser

BI Norwegian Business School

Date Written: October 16, 2020

Abstract

With zero capital structure rebalancing costs, dynamic tradeoff theory predicts that firms stay at their leverage targets with more profitable firms staying at higher leverage. This prediction is rejected by the robustly negative correlation between leverage and profitability. When rebalancing costs are added to this theory, it predicts a positive leverage-profitability correlation only in periods where companies pay these costs and actively rebalance their capital structures. However, we show that the correlation is negative when firms issue debt and distribute the proceeds to shareholders---precisely the case where the theory predicts it should be positive. Our results thus resurrect the leverage-profitability puzzle.

Keywords: Capital structure, tradeoff theory, dynamic inaction, recapitalizations, leverage-profitbility correlation, pecking order

JEL Classification: G32

Suggested Citation

Eckbo, B. Espen and Kisser, Michael, The leverage-profitability puzzle ressurected (October 16, 2020). Review of Finance, forthcoming, Available at SSRN: https://ssrn.com/abstract=3166707 or http://dx.doi.org/10.2139/ssrn.3166707

B. Espen Eckbo (Contact Author)

Tuck School of Business at Dartmouth ( email )

Hanover, NH 03755
United States
603-646-3953 (Phone)
603-646-3805 (Fax)

HOME PAGE: http://tuck.dartmouth.edu/faculty/faculty-directory/b-espen-eckbo

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Michael Kisser

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

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