A Bargaining Theory of the Leverage-Profitability Relationship

This paper shows that a static trade-off model generates a negative cross-sectional relationship between leverage and profitability once ex ante Nash bargaining over the perpetual debt coupon is introduced. The central mechanism works as follows: higher shareholder bargaining power lowers the negotiated coupon, which reduces leverage — the ratio of debt to equity — and shrinks the interest tax shield, thereby lowering firm value for fixed earnings before interest and taxes (EBIT) and raising the earnings yield. Heterogeneity in bargaining power across firms thus produces a negative co-movement between leverage and valuation-based profitability in the cross-section. A key implication concerns how this mechanism maps into accounting data. Under historical-cost measurement (GAAP), book assets do not respond to the bargaining environment, so the mechanism is attenuated in reported return on assets (ROA). Under fair-value-oriented measurement (IFRS), book assets track enterprise value more closely, making the negative relationship more visible in the data. This asymmetry has particular relevance for multinational groups operating across jurisdictions with heterogeneous accounting standards, where within-group comparisons of leverage and profitability may be systematically distorted by the coexistence of the two regimes.