The profits-leverage puzzle revisited

Murray Z. Frank, Vidhan K. Goyal

Research output: Contribution to journalArticle

12 Scopus citations

Abstract

The inverse relation between leverage and profitability is widely regarded as a serious defect of the trade-off theory. We show that the defect is not with the theory but with the use of a leverage ratio in which profitability affects both the numerator and the denominator. Profitability directly increases the value of equity. Firms do take the predicted offsetting actions. They issue debt and repurchase equity when profitability rises, and retire debt and issue equity when profitability falls. Consistent with variable transactions costs, the adjustment is not generally sufficient to fully undo the profitability shocks. Accordingly, on average the leverage ratio falls as profitability rises.

Original languageEnglish (US)
Pages (from-to)1415-1453
Number of pages39
JournalReview of Finance
Volume19
Issue number4
DOIs
StatePublished - Jul 1 2015

Keywords

  • G32

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