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Refinancing and Mean Reversion In Earnings
We propose an alternative to the standard nonstationary earnings dynamics framework for studying refinancing decisions by building a dynamic two-stage trade-off model with refinancing for firms following mean reverting earnings. The model predicts a negative relation between profitability and leverage ratios at refinancing, showing that firms with earnings below their long-term profitability increase their leverage ratios at refinancing, whereas firms currently above their long-term profitability decrease their leverage ratios at refinancing. Our empirical results confirm the prevalence of mean reversion in earnings among US firms and largely corroborate with theoretical model predictions supporting a negative relation of profitability with leverage ratios at refinancing. We also find that on average, firms’ leverage ratios increase during refinancing, driven mostly by firms on the lowest quantile with low leverage ratios.