Earnings mean reversion and dynamic optimal capital structure

We formulate a trade-off model that integrates mean reversion in earnings, encompassing dynamic financing decisions that entail both the initial leverage selection and the subsequent decision related to the financing of a growth option. We identify that higher earnings mean reversion speed increases both initial and subsequent leverage ratios for growth option financing and accelerates investment, revealing the volatility-mitigating role of mean reversion speed. Furthermore, our analysis reveals a U-shaped relation between profitability and leverage, influenced by the presence of growth options. In contrast, higher long-term profitability has a positive relationship with leverage, highlighting the differential impact of long-term versus contemporaneous profitability on leverage. The model also yields further implications for corporate policies regarding debt priority structure, investment timing, default thresholds, and credit spreads, contingent on earnings mean reversion dynamics. Our empirical analysis reveals the prevalence of mean reversion in earnings among US firms and provides a comparison of capital structure decisions of firms with mean reverting earnings against firms having non-stationary earnings dynamics.