Operating Inflexibility, Profitability and Capital Structure

Nicholas Zhiyao Chen (), Jarrad Harford () and Avraham Kamara
Additional contact information
Nicholas Zhiyao Chen: ICMA Centre, Henley Business School, University of Reading
Avraham Kamara: University of Washington - Michael G. Foster School of Business

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: By introducing operating inflexibility into the standard capital structural model, we build a two-regime model to show that the negative relation between profitability and financial leverage is not evidence against the trade-off model. Whereas firms increase their contractual operating costs when they are profitable, they have difficulty reducing them when they enter distress. We find strong empirical evidence supporting our theoretical predictions. First, highly profitable firms with higher inflexible operating costs precautionarily choose lower financial leverage ex ante to reduce the future probability of default. Second, firms with high operating flexibility choose high financial leverages in good states that increase default probability because they have the flexibility to downsize operating costs in bad states. Lastly, production costs that can be adjusted instantaneously absorb downside demand shocks, resulting in a low default probability and high financial leverage.

Keywords: capital structure; financial leverage; trade-off theory; operating inflexibility; profitability; default risk (search for similar items in EconPapers)
JEL-codes: G32 (search for similar items in EconPapers)
Pages: 68 pages
Date: 2013-09
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID23 ... ctid=2209070&mirid=1 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:rdg:icmadp:icma-dp2013-09

Access Statistics for this paper

More papers in ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading Contact information at EDIRC.
Bibliographic data for series maintained by Marie Pearson ().