Can the Changes in Capital Structure Due to Operating Profits Accumulate in the Long Term?

Abstract

This paper examines whether the changes in capital structure due to operating profits can accumulate in the long run. We find that historical operating profits have economically and statistically significant long-term effect on capital structure and that the weighted average historical profits over the entire firm history have more explanatory power on current cross-sectional capital structure variations than the well accepted lagged leverage determinants do. Our findings imply that firms’ capital structures are to a large extent the outcome of cumulating historical operating profits. The findings in our paper raise a new challenge for the trade-off theory of capital structure, as neither the static trade-off theory nor the modified trade-off theory with partial adjustment can accommodate with the evidence of strong long lasting negative effect of weighted average historical profits on capital structure.

Keywords: capital structure, profitability, trade-off theory, pecking order theory

JEL Classification: G32