Operating inflexibility, profitability and capital structure

By introducing operating inflexibility into the standard capital structural model, we build a two-regime model to show that the negative relation between profitability and financial leverage is not evidence against the trade-off model. Whereas firms increase their contractual operating costs when they are profitable, they have difficulty reducing them when they enter distress. We find strong empirical evidence supporting our theoretical predictions. First, highly profitable firms with higher inflexible operating costs precautionarily choose lower financial leverage ex ante to reduce the future probability of default. Second, firms with high operating flexibility choose high financial leverages in good states that increase default probability because they have the flexibility to downsize operating costs in bad states. Lastly, production costs that can be adjusted instantaneously absorb downside demand shocks, resulting in a low default probability and high financial leverage.