CORPORATE EARNINGS AND CORPORATE LEVERAGE: MANAGERS ARE MAKING THE RIGHT DECISIONS ON DEBT

Companies enjoying high earnings are right to have relatively less debt despite the tax benefits of greater leverage, according to new research by Sudipto Sarkar and Fernando Zapatero published in the October 2003 Economic Journal. The reason is that corporate earnings are 'mean-reverting' - they tend eventually to go back to the long-run average level - and with mean-reverting earnings, the ideal leverage ratio actually falls when earnings rise and vice versa.

Corporate leverage decisions are among the most important decisions made by finance executives. This is because excessive usage of leverage can lead to financial distress and even bankruptcy. On the other hand, insufficient usage of leverage is also undesirable because the interest paid to borrowers is tax-deductible, hence using too little debt results in under-utilisation of the valuable tax shields.

Clearly, choosing the appropriate degree of leverage is important. Not surprisingly, there is a large academic literature on this topic, as well as discussion of the topic in corporate finance textbooks. According to the well-known 'trade-off theory' that is taught in virtually all introductory finance courses in business schools, the optimal leverage ratio increases when earnings are higher.

But the observed relationship in this case is exactly the opposite: corporate leverage ratios are in fact lower when earnings are higher. Thus, either the theory is incorrect or corporate managers are making irrational and non-optimal leverage decisions.

This study shows that, in this instance, the managers have got it right. Corporate earnings are 'mean-reverting' (they tend eventually to go back to the long-run average level) and with mean-reverting earnings the optimal leverage ratio actually falls when earnings rise and vice versa. Thus, this modification of standard theory is consistent with the behaviour of the corporate sector. This is the major contribution of the work.

There are two other important theoretical results. First, the speed of earnings mean-reversion is an important determinant of the optimal leverage ratio.
Second, firm risk has hitherto been measured by the volatility of earnings. The researchers show, however, that earnings volatility is not a sufficient measure of firm risk. They suggest an improved measure that also incorporates the speed of earnings reversion.

The second part of the research takes the theory to the data. The real-world evidence comes from the leverage decisions and other characteristics of large US corporations in the Standard & Poor's 500 Index.
The data demonstrate that earnings mean-reversion does drive the observed negative relationship between earnings and leverage ratio. They also demonstrate that earnings volatility is not a sufficient measure of firm risk, as predicted by the theory.

ENDS

Notes for Editors: 'The Trade-off Model with Mean Reverting Earnings: Theory and Empirical Tests' by Sudipto Sarkar and Fernando Zapatero is published in the October 2003 issue of the Economic Journal.

Sarkar is at McMaster University; Zapatero is at the University of Southern California.

For Further Information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com); or Sudipto Sarkar via email on sarkars@mcmail.cis.mcmaster.ca.