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The Leverage–Profitability Puzzle Resurrected
[Is cash negative debt? A hedging perspective on corporate financial policies]

Author

Listed:
  • B Espen Eckbo
  • Michael Kisser

Abstract

With zero capital structure rebalancing costs, dynamic trade-off 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.

Suggested Citation

  • B Espen Eckbo & Michael Kisser, 2021. "The Leverage–Profitability Puzzle Resurrected [Is cash negative debt? A hedging perspective on corporate financial policies]," Review of Finance, European Finance Association, vol. 25(4), pages 1089-1128.
    • Handle: RePEc:oup:revfin:v:25:y:2021:i:4:p:1089-1128.
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    File URL: http://hdl.handle.net/10.1093/rof/rfaa032
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    Citations

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    Cited by:

    1. 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.
    2. Kisser, Michael & Rapushi, Loreta, 2022. "Equity issues, creditor control and market timing patterns: Evidence from leverage decreasing recapitalizations," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 196-216.
    3. Chaigneau, Pierre, 2023. "Capital Structure with Information about the Upside and the Downside," MPRA Paper 121397, University Library of Munich, Germany.

    More about this item

    Keywords

    Capital structure; Trade-off theory; Issue costs and benefits; Dynamic rebalancing; Leverage–profitability correlation;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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