Revisiting the Negative Profitability Effect on Capital Structure: Pecking-Order or Trade-Off Hypothesis

Abstract

This paper investigates the empirical relationship between profitability and leverage ratios using a sample of Taiwan-listed firms. Like the U.S. evidence, we do find such a negative profitability-leverage relationship for the full sample. Although the profitability effect is still negative for passive firms that do not issue any security, it is positive for firms that issue both equity and debt but do not invest in fixed assets. Furthermore, while the dual issuers without investment adjust their leverages toward their targets the fastest, passive firms do so the slowest. Overall, our results on the profitability effect on leverage are consistent with the dynamic trade-off hypothesis that accounts for costly adjustments.