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


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    This paper was presented at the 2001 Rutgers Conference on Capital Structure, Lancaster University, McMaster University, and University of Southern California. We appreciate comments received from participants at these seminars, as well as Peter McKay, Mark Weinstein and especially David Mauer. We also thank two anonymous referees for their feedback and for many useful suggestions, and the editor Mike Wickens for his guidance. Finally, we thank John Graham for access to his corporate tax rate estimates. We are responsible for any remaining errors. Sudipto Sarkar acknowledges financial support from a McMaster University Research Grant.


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.