The Trade-Off Model with Mean Reverting Earnings: Theory and Empirical Tests

The biggest criticism of the traditional trade-off theory of capital structure is that it predicts a positive relationship between earnings and leverage, contradictory to well-established empirical evidence. One possible explanation for this discrepancy might lie in the mean reverting nature of corporate earnings. We therefore re-formulate the trade-off model, with mean reverting earnings. The optimal leverage ratio is computed in the usual manner, by trading off the tax benefits of debt with its associated financial distress costs. Our main result is a negative relationship between optimal leverage and earnings. The model also highlights the importance of the earnings reversion parameter in determining the optimal capital structure. The major implications of the model are supported by empirical tests carried out with Compustat data for firms in the S&P 500 Index.