The Trade‐off Model with Mean Reverting Earnings: Theory and Empirical Tests*

The ‘trade‐off theory’ of capital structure predicts a positive relationship between earnings and leverage, contradictory to well established empirical evidence. Since corporate earnings are known to be mean reverting, we reformulate the trade‐off model with mean reverting earnings. We show that, with mean reverting earnings, there should be a negative relationship between optimal leverage and the current earnings level. The model also illustrates the importance of the earnings reversion parameter in the determination of capital structure. The major implications of the model are supported by empirical tests carried out with a sample of firms in the S&P 500 Index.