Exploring nonlinear linkage between profitability and leverage: US multinational versus domestic corporations

Abstract

This study examines the impact of profitability on the capital structure decision of US multinational and domestic corporations. The findings reveal that the relationship between multinational corporations’ (MNCs') profitability and their leverage ratios is U-shaped and nonlinear, while this nonlinear relation does not exist for domestic firms (DCs). This nonlinear relationship indicates that the effect of profitability on multinational corporations' leverage depends on the levels of their profitability. Consistent with the dominance of the pecking order theory, lower-profitability MNCs have a tax shield advantage that does not outweigh the information asymmetry costs of debt financing. Conversely, higher-profitability MNCs have a tax shield advantage that outweighs the information asymmetry costs of debt financing. The findings are robust after using two different classifications for multinational firms, including foreign tax and foreign sales; after applying an alternative methodology and during different time horizons.