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Profitability and Financial Leverage: Evidence from a Quasi-Natural Experiment

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  • Davidson Heath

    (David Eccles School of Business, University of Utah, Salt Lake City, Utah 84112)

  • Giorgo Sertsios

    (Lubar School of Business, University of Wisconsin–Milwaukee, Milwaukee, Wisconsin 53211)

Abstract

The relationship between profitability and leverage is controversial in the capital structure literature. We revisit this relation in light of a novel quasi-natural experiment that increases market power for a subset of firms. We find that treated firms increase their profitability throughout the treatment period. However, they only transiently reduce financial leverage, gradually reverting to their preshock level. Firms respond differently according to size with large firms gradually adjusting their leverage toward a new target and small firms reducing it. The patterns are broadly consistent with dynamic trade-off models with both fixed and variable adjustment costs.

Suggested Citation

  • Davidson Heath & Giorgo Sertsios, 2022. "Profitability and Financial Leverage: Evidence from a Quasi-Natural Experiment," Management Science, INFORMS, vol. 68(11), pages 8386-8410, November.
    • Handle: RePEc:inm:ormnsc:v:68:y:2022:i:11:p:8386-8410
    DOI: 10.1287/mnsc.2021.4235
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    References listed on IDEAS

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