Prof. Vidhan Goyal (Hongkong University of Science and Technology)

Program

• Date: 10.08.2011
  Time: 18:00-19:30
  Location: Raum E004, Kaulbachstraße 45, 80539 München

The Profits-Leverage Puzzle Revisited

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 trade-off theory. We disagree. Contrary to Myers (1993), highly profitable firms typically issue debt and repurchase equity, while the lowest profit firms tend to raise external funds -particularly equity. The typical issuance is in the direction predicted by the trade-off. It is also true that more profitable firms experience an increase in both the book value of equity and the market value of equity. The effect of profits on equity drives the negative coefficient in the usual leverage regression, thus giving a misleading impression. Transaction costs may be important because we find that large firms make more active use of debt, while small firms make more active use of equity. Furthermore, poor market conditions lead to reduced use of external finance. The impact is particularly strong on small and low profit firms.