Profits and Capital Structure

It is well known that in a leverage regression, profits are negatively related to leverage. The literature (e.g., Myers, 1993; Fama and French, 2002) considers this to be a key rejection of the static trade-off theory. In this paper, we show that: 1. The literature has misinterpreted the evidence as a result of the wide-spread use of familiar but empirically misleading, leverage ratios. 2. More profitable firms experience an increase in both book equity and the market value of equity. 3. Empirically, they react as in the trade-off theory. Highly profitable firms typically issue debt and repurchase equity, while low profit firms typically reduce debt and issue equity. 4. Firm size matters. Large firms make more active use of debt, while small firms make more active use of equity. 5. In a trade-off model, financing decisions depend on market conditions ('market timing'). Empirically, poor market conditions result in reduced use of external finance. The impact is particularly strong on small and low profit firms.