The Effect of Capital Structure on Firm Profitability: Empirical Evidence from the United States, 1993-2015

Abstract

Since Modigliani and Miller’s seminal paper in 1958 on the independence of a firm’s market value from its capital structure, extensive research has yet to reach a consensus on the validity of their propositions. Capital structure remains an important decision for firm managers, especially in the low interest rate environment following the recent recession and now as rates begin to climb. This paper seeks to provide empirical evidence of the benefits or costs of debt financing in relation to a public firm’s primary purpose, maximizing shareholder value, regardless of the exact mechanism that capital structure follows. Using Compustat panel data on 14,400 firms in the United States from 1993 to 2015, I conduct time and entity fixed effects regressions to investigate the effect of financial leverage ratios on market-based and accounting-based measures of firm profitability. I find that short-term, long-term, and total financial debt to capital ratios have a negative affect on Tobin’s Q, a market-based measure of profitability. In regressions on accounting-based measures of profitability, all three measures of leverage have a small positive effect on return on equity, and short-term and total leverage ratios have a small positive effect on return on assets.