Earnings Dynamics and Optimal Capital Structure

We develop a dynamic trade-off model with mean-reversion in earnings and a growth option and provide predictions on the impact of long-term profitability, mean reversion speed, volatility of earnings and debt priority structure on firm value, the dynamics of leverage and credit spreads and the optimal timing of growth option investment and default. Our model shows that the relation between current profitability and leverage follows a U-shape driven by growth options. We provide empirical evidence on the relation of leverage with profitability and other common factors used in the literature providing a first comparison between mean reverting and non-stationary firms