Leverage, Risk, Market Structure and Profitability

THIS paper attempts to analyze and measure the relationships among leverage, market structure, risk and profitability. It develops a theoretical model relating these variables and then tests the model using cross-section data on 228 United States manufacturing firms. An additional test is made using data from 85 industries with both tests covering the 1960's. Recently numerous studies have tested the relationship between market structure and rate of return (Hall and Weiss, 1967; Samuels and Smyth, 1968; Fisher and Hall, 1969; Shepherd 1971, 1972; Stigler, 1963; Kilpatrick, 1968; Collins and Preston, 1969; and Gale, 1972). Several of these authors have included a risk variable or a financial structure variable or both in a linear regression model. They have commonly represented the degree of risk by the variability of profits over time (hereafter denoted o).'More recently, Gale (1972) has used financial structure (measured as the equity to assets ratio) to represent risk. Still other economists suggest that leverage may have an independent influence on the rate of return, unrelated to risk (Stigler, 1963; Scherer, 1970; Jean, 1970). At this point a more general test may resolve the alternative hypotheses. This paper will test both the Gale hypothesis and the Stigler, et al. hypotheses using a simultaneous 3-equation model.