Risk, Leverage and Profitability: An Industry Analysis

T HIS study investigates the effect of financial leverage, or relatively greater use of debt capital, on industry profitability. Recently at least two cross-section studies have yielded the surprising result that systematically higher rates of return are earned by firms with relatively low leverage. Measuring leverage inversely as the ratio of equity to assets,' one would expect the rate of return on equity and this ratio to vary in opposite directions, lower values of equity/assets and the associated riskier bond intensive capital structures implying higher equilibrium profit rates, ceteris paribus.2 But so far the evidence has gone the other way. Fred D. Arditti (1967) calculated expected profit rates for firms as a geometric average of past rates of return and regressed this variable on the ratio of debt to equity.3 His measure of leverage appeared with a negative sign in all of his regressions. And in a paper dealing with the determinants of firm profitability, Marshall Hall and Leonard Weiss (1967) found that equity/assets, which is inversely related to leverage, had a significantly positive effect on profits on equity when market structure conditions were held constant.4 They noted, . . a possible after-the-fact explanation is that relatively profitable firms take some of the exceptional returns in the form of reduced risks. (1967, p. 328.) Thus profitability may affect leverage, and leverage may affect profitability. On grounds that the direction of causation between leverage and profitability may run in both directions, this paper develops and tests a model consisting of two equations, one explaining industry profitability in terms of the usual market structure variables plus leverage and the other a new equation incorporating risk variables to explain leverage.