Understanding the Roles of the Market-to-Book Ratio and Profitability in Corporate Financing Decisions∗

It is well documented that the market-to-book ratio and profitability are two key capital structure determinants. However, because the related empirical evidence can be explained by both the tradeoff theory and the costly external financing theory (which includes both the pecking order theory and the market timing hypothesis), a large controversy remains in the finance literature regarding the economic interpretation of these variables. This study focuses on scenarios where the two theories have drastically different or even opposite predictions about these variables. In each case, we find strong evidence in support of the costly external financing theory but inconsistent with the tradeoff theory. We conclude that firms with higher marketto-book ratios are more likely to issue equity not because they intend to downwardly adjust their target leverage ratios, but because they face lower external financing costs. Similarly, firms with higher profitability are more likely to issue debt, not because they intend to move toward their target leverage ratios, but because they face lower debt financing costs. These conclusions remain firm with extensive robustness checks, alternative variable measures, and different sample choices. JEL Classification: G32