Staff Working Paper No. 962
By Albert Banal-Estanol, Paolo Siciliani and Kyoungsoo Yoon
We investigate the relationship between profitability and financial leverage for US listed non-financial corporations by taking into account the degree of product similarity among competing firms, which can drive intense pricing rivalry thus undermining the sustainability of high price-cost mark-ups. We find that in markets characterized by high price-cost mark-ups notwithstanding high product similarity, the relationship between profitability and financial leverage is negative. Instead, in the rest of the markets we find a positive relationship, consistent with the dynamic trade-off theory of corporate finance, whereby firms increase their degree of financial leverage in response to profitability improvements. Not only do firms exposed to comparatively higher degree of product substitutability make less use of financial leverage, but they also rely relatively less on long-term debt. The difference is especially attributable to the period after the great financial crisis.