Product Market Competition and Capital Structure: Evidence from Import Penetration *

Jin Xu

Krannert School of Management, Purdue University, West Lafayette, IN 47906, United States

Abstract

I find that firms experiencing increases in import competition significantly reduce their leverage

ratios by issuing equity and selling assets to repay debt. Using import tariffs and foreign

exchange rates as instrumental variables for import penetration, I show that these results are not

manifestations of endogenous relations between import competition and leverage. The results are

consistent with traditional tradeoff models of capital structure that predict a positive relation

between book leverage and future expected profitability. Further evidence suggests that import

competition affects leverage through changes in the tradeoff between the tax benefits of debt and

the costs of financial distress.

JEL Classification Codes: D43, F12, G32, G33

Keywords: profitability, leverage, import competition

* I’m grateful to the members of my dissertation committee, Steve Kaplan, Doug Diamond, Anil
Kashyap, Marianne Bertrand, and Josh Rauh for guidance and many discussions. The paper has benefited
greatly from constructive comments from an anonymous referee. I also wish to thank Bill Schwert, the
editor, Dave Denis, Diane Denis, Mara Faccio, Jay Hartzell, John McConnell, Steve McKeon, Atif Mian,
Per Strömberg, Amir Sufi, Michael Weisbach, Deniz Yavuz and seminar participants at the University of
Chicago, UC Davis, UC Irvine, Chinese University of Hong Kong, Columbia, Iowa, Notre Dame,
National University of Singapore, Purdue and Rice University, and participants of the 2006 NBER fall
meetings, and the 2008 WFA for helpful comments. Last but not least, I thank John Romalis and Peter
Schott for making their data available and Nicholas Husen for research assistance. Any errors remain my
own.
Tel: +1 765 496 2441
Email address: xu68@purdue.edu

Electronic copy available at: http://ssrn.com/abstract=972816

1. Introduction

Numerous studies empirically test the relative merits of various capital structure models by

analyzing the cross-section of leverage ratios. One particular result highlighted in this literature

is the negative relation between leverage and profitability (e.g., Baker and Wurgler 2002; Rajan

and Zingales, 1995; Titman and Wessels, 1988). Because traditional tradeoff models of capital

structure predict a positive relation between book leverage and profitability, the empirical

regularity of an inverse relation is often viewed as a particularly strong indictment of tradeoff

models (e.g., Fama and French, 2002; Myers, 1993; Shyam-Sunder and Myers, 1999). More

recently, studies that incorporate adjustment costs (e.g., Leary and Roberts, 2005; Strebulaev,

2007) show that an inverse relation between leverage and profitability can be consistent with a

dynamic tradeoff model. Nonetheless, direct evidence of the predicted positive relation between

book leverage and profitability is scarce.

One reason for the inability of cross-sectional tests to provide results consistent with the

tradeoff theory is that the tests examine realized past profitability while the theory focuses on

future expected profitability. In traditional tradeoff models, leverage is determined by the

tradeoff between the present value of expected costs of financial distress and the present value of

expected debt tax shields, both of which depend on future expected profitability but are not

affected by realized past profitability. Because a change in profitability in the past does not

necessarily reflect a change in expected future profitability, tests based on past profitability do

not test the prediction of the tradeoff theory.

In addition, with adjustment costs of capital structure, negative correlations between leverage

ratios and past profitability can emerge mechanically (e.g., Myers, 1993; Strebulaev, 2007). For

instance, after a firm experiences an increase in profitability, ceteris paribus, its assets and value

Electronic copy available at: http://ssrn.com/abstract=972816

increase. This will lead to lower book and market leverage if the firm chooses not to either buy

back shares or issue debt.

In this paper, I propose an empirical setting in which future expected profitability changes

exogenously to examine the relation between expected profitability and leverage. A large

empirical literature has established the result that increases in import competition lead to

significant reductions in domestic profitability. 1 Therefore, I study the impact of changes in

import competition on changes in domestic firms’ financial leverage in an attempt to provide a

direct test of the traditional tradeoff theory.

To be clear, empirical predictions about the relation between expected profitability and

leverage depend on the measure of leverage and the magnitude of leverage adjustment costs.

Regarding book leverage, the tradeoff theory predicts that it should be positively correlated with

expected profitability because higher expected profitability corresponds to higher benefits of

debt and lower costs of financial distress. Such a relation will be observed empirically if the

costs of adjusting leverage are relatively low and adjustments occur relatively quickly. For

market leverage, the tradeoff theory does not have a definite prediction since firm value also

increases with expected profitability. Furthermore, with relatively high adjustment costs and

slow adjustments, market leverage may appear to be negatively correlated with expected

profitability because firm value increases before firms adjust their levels of debt.

Using a sample of U.S. public manufacturing firms between 1989 and 2004, I first examine

how changes in domestic profit prospects are associated with changes in import competition.

1
There is ample empirical evidence on the effect of import competition on domestic profitability, such as DeRosa

and Goldstein (1981), Katics and Petersen (1994), Pagoulatos and Sorensen (1976) and Pugel (1980) on the U.S.,

Conyon and Machin (1991) and Murfin and Cowling (1981) on the U.K., and Djankov and Hoekman (1998),

Levinsohn (1993) and Roberts and Tybout (1996) on less-developed markets.

2
Consistent with prior literature, I find that both the profit margins and the market shares of

domestic firms decrease significantly with increases in import penetration. Moreover, predicted

profit margin based on import penetration is relatively persistent through time. These results

validate the empirical setting used in this study.

To investigate the impact of changes in import competition on changes in leverage, I start by

conducting multivariate panel regressions of leverage on import penetration. Using industry

fixed effects to control for cross industry differences in leverage and import penetration and year

fixed effects to control for common time trends, I find that increases in import penetration are

statistically and economically significantly related to decreases in both book and market leverage.

Given that increases in import penetration reduce expected profitability, the results are consistent

with traditional tradeoff models that predict a positive association between expected profitability

and book leverage. The results also suggest a positive correlation between expected profitability

and market leverage. Since both results differ from what one would expect in the case of slow

adjustments, they also imply that firms experiencing changes in import competition promptly

adjust their leverage.

There are, however, alternative explanations of these results. For example, an omitted factor

could affect both import competition and leverage. Leverage could also have a feedback effect

on import competition, e.g., through a firm’s competitive strategy in product markets. In addition,

import competition could affect leverage through a channel other than profitability. I perform

four additional tests to assess these alternative interpretations. Importantly, I introduce two

instrumental variables (IVs) to estimate the causal effects of import competition on leverage and

use these IVs in the examination of all alternative explanations.

3
 The two instrumental variables for import penetration are industry level import tariffs and

foreign exchange rates. Tariff rates and exchange rates are correlated with import penetration,

but there is little reason to believe that either is directly influenced by individual firms’

profitability or capital structure policies.2 First, I conduct panel data IV regressions to estimate

the effects of import competition on firms’ leverage ratios that are not contaminated by

endogeneity. The IV regressions confirm the finding of negative associations between import

competition and both book and market leverage ratios and suggest causal effects that are

economically larger than those implied by the simple multivariate regressions. Therefore, the

negative correlations between import competition and leverage ratios are unlikely to be driven by

an omitted variable or a feedback effect.

Second, to further address the concerns of an omitted factor or a feedback effect, I examine

the exogenous appreciation of the U.S. dollar during 1995-2002. Because the reasons for this

event are entirely unrelated to individual firms’ profitability or capital structure policies, as

discussed later, the event drives exogenous increases in import competition. Depending on the ex

ante level of import penetration, industries differ in their exposure to exchange rate risk.

Industries penetrated more by imports are more sensitive to changes in exchange rates (Feinberg,

1986, 1989). Using a cross-sectional regression specification, I find negative correlations

between initial import penetration and the 1995-2002 changes in both book and market leverage,

thus confirming the negative effects of import competition on leverage.

Third, I investigate whether there is cross-sectional heterogeneity in the causal effects of

import competition on leverage as one should expect. In particular, I identify firms that are more

sensitive to changes in import competition and examine whether the effects of import

2
I discuss the validity of these instruments further in Section 2.

4
competition on leverage are stronger for these firms. I expect the effects of import competition

on leverage to be stronger for firms with less unique production technology, firms with weaker

financial strength, firms that lose market share, and firms in more competitive industries. By

employing IV regressions in subsamples of firms classified along each of these dimensions, I

find evidence consistent with the predictions. This empirical evidence further alleviates the

concern that the effects of import competition on leverage ratios are spurious results of an

omitted variable.

Fourth, I seek evidence that import competition affects leverage through the profitability

channel. The tradeoff theory predicts an increase in book leverage when expected profitability

increases because the costs of financial distress decrease and the tax benefits of debt increase.

Through this mechanism, firms with higher ex ante default probabilities should respond to

intensified competition more strongly because they are more susceptible to bankruptcy. Firms

with lower marginal tax rates should also respond to intensified competition more strongly

because the marginal tax benefit of debt is more sensitive to changes in profitability for these

firms. In subsample IV regressions, I find that the effects of import competition on leverage are

significantly larger for firms with higher default probabilities and firms with lower marginal tax

rates, which is consistent with the predictions of the tradeoff theory.

Finally, to understand the mechanics of the leverage changes, I examine security issuances

and retirements and changes in assets following reductions in tariffs and the 1995-2002 dollar

appreciation, respectively. I find that net equity issuances (issuances minus repurchases) are

higher and net debt issuances and asset growth are lower following tariff reductions. Similarly,

during the dollar appreciation period, firms more subject to exchange rate risk issue more equity

and less debt. These results suggest that, when import competition intensifies, firms adjust

5
toward optimal leverage by issuing equity and by selling off assets and using the proceeds to pay

down debt. The results are direct evidence for the active adjustment of capital structure by firms

under increased import competition.

This paper is related to the debate on whether there exists an optimal capital structure. While

traditional tradeoff theories hold that optimal leverage exists and is determined by the tradeoffs

between various benefits and costs of debt (e.g., Jensen and Meckling, 1976; Modigliani and

Miller, 1963; Myers, 1977), opponents contend that there is no target leverage and capital

structure is the result of information asymmetry and adverse selection (e.g., Myers and Majluf,

1984), stock market returns (Welch, 2004) or the cumulative effects of market timing efforts by

managers (Baker and Wurgler, 2002). The empirical regularity of a negative correlation between

profitability and book leverage serves the latter arguments well while it appears to contradict

traditional tradeoff models. My results show that changes in expected profitability generated

from changes in import competition are positively associated with changes in book leverage,

hence providing direct evidence consistent with tradeoff theories. The results that firms reduce

leverage by issuing equity and repaying debt under intensified import competition constitute

further evidence that firms actively adjust toward their target leverage.

The rest of the paper is organized as follows. In Section 2, I discuss the setting and introduce

the data. In Section 3, I present multivariate test results of the effects of import competition on

leverage ratios. Section 4 examines the mechanics of how leverage adjustments occur. Section 5

concludes.

6
2. The setting and data

2.1. Theoretical predictions about the relation between profitability and leverage

I develop a single-period model based on Bradley, Jarrell and Kim (1984) as an example of

the traditional tradeoff models to illustrate the predictions of such models about the relation

between profitability and leverage. In particular, the model attempts to emphasize the distinction

between the effects of past profitability and future profitability on both book and market leverage

ratios and how these relations are affected by adjustment costs.

I consider a firm with total book assets of A at the beginning of the period. Define as the

firm’s total earnings before interests and taxes per dollar of total assets, which follows a

distribution with an expected value of , a probability density function of and a cumulative

probability function of . For simplicity, I assume that the firm has zero non-debt tax shields

and that personal tax rates on income from debt and stocks are both zero. (One could easily show

that all analyses in the model will still be valid if non-zero values are considered for these factors

instead.) The uncertain end-of-period return (per dollar of total assets A) to the firm’s investors

(including stockholders and debtholders) can be written as follows

1 ,
= 1 , 0 . (1)
0, 0

In this equation, is the total end-of-period promised payment to debtholders per dollar of

total assets A. k is the ex ante cost of financial distress per dollar of the end-of-period firm value.

tc represents corporate tax rate. The beginning-of-period firm value V (per dollar of total assets A)

then equals the expected present value of the end-of-period return to investors.

Eq. (1) has implications about the relation between profitability and firm assets or value.

Suppose that expected future earnings increases. Existing firm assets A is not affected but firm
7
value V will increase because both the end-of-period return to investors in the state where is

positive and the probability that is positive will increase.3 By contrast, after experiencing an

increase in realized profitability without a change in expected future profitability, the firm’s

assets will increase (by the amount of increase in after-tax earnings or less depending on the

magnitude of realized earnings relative to debt). Firm value will also increase proportionally with

the increase in firm assets.

Next I analyze the relation between profitability and optimal debt. By definition, optimal

debt is the level of debt that maximizes the beginning-of-period firm value. Assuming risk-

neutral investors and defining r0 as one plus the rate of return on default-free tax-exempt bonds,

the beginning-of-period firm value V can be written as

1 1 / . (2)

The first order condition for optimal debt is that the following partial derivative of V with

respect to equals zero,

1 / . (3)

Eq. (3) shows the benefit and cost tradeoff of debt financing. The first term captures the

marginal tax advantage of debt and the second term represents the marginal expected cost of

financial distress.

Eq. (3) implies a positive correlation between expected earnings and the optimal level of debt.

This is because, for any given , an increase in expected earnings entails a decline in both

and , which means a higher tax benefit of debt and a lower cost of financial distress.

Optimal debt will increase and one can also show that this increase will not exceed the increase

3
Roughly speaking, with relatively high expected profitability (i.e., if the probability of financial distress is small),
the change in firm value will be proportional to the change in expected profitability.

8
in expected earnings.4 Eq. (3) also suggests that realized past profitability should have no impact

on the optimal level of debt (per dollar of assets) because only the distribution of future earnings

matters in the benefit and cost tradeoff for debt.

To summarize, the above analyses suggest that increases in expected future profitability will

lead to no change in existing firm assets but increases in both firm value and optimal debt. These

effects imply a positive association between expected profitability and book leverage and an

ambiguous relation between expected profitability and market leverage. Under certain conditions,

it is possible that the change in optimal debt will exceed the change in firm value such that

market leverage will also increase with expected profitability.5

The analyses also suggest that increases in realized past profitability will result in increases

in firm assets and value but no change in optimal debt per dollar of assets. These effects imply a

zero correlation between past profitability and both book and market leverage. Thus, the model

predicts that a positive relation exists only between expected profitability and book leverage and,

4
Assume that earnings is normally distributed and expected earnings increase from to +a. Also use to

denote the optimal level of debt before the increase in earnings, i.e., = 1 / =0. For

any given , the first order condition for the optimal debt decision after the increase in expected earnings becomes

1 / . Evaluate this equation at = and, after a substitution, one can

obtain that / , which is less than zero. This result implies that the new optimal level of debt

is less than . In particular, when k and are relatively small, can be very close to 0 and the new

optimal debt will almost equal .

5
In the example in footnote 4, when k and are relatively small, the new optimal debt almost equals .
Assuming that the increase in firm value is proportional to the earnings increase and defining as firm value
corresponding to , the new market leverage ratio will be roughly / 1 , which can be rewritten as

1 / 1 . Since should be less than for a typical firm, the new market leverage ratio is greater

than / , the old market leverage ratio.

9
with some ambiguity, between expected profitability and market leverage. A test of these

predictions therefore requires a proxy for expected profitability.

Note that the model is a static model and, therefore, its predictions are based on the premise

that capital structure adjustments are instantaneous. With adjustment costs, however, firms do

not adjust their capital structures quickly after deviations from optimal leverage occur. In the

case of book leverage, the delay in adjustments can lead to its weakened positive or even zero

correlation with expected profitability. In the case of market leverage, such delay can result in an

inverse relation between expected profitability and market leverage, because firm value increases

immediately with a change in expected profitability. These caveats should be kept in mind when

one interprets results in this study.

In a peripheral note, the delay in capital structure adjustments also implies that increases in

past profitability will result in negative changes in book and market leverage ratios since firm

assets and value increase with past profitability. This prediction is consistent with prior literature

that documents a negative correlation between profitability and leverage (e.g., Titman and

Wessels, 1988).

2.2. Relation between import competition and domestic profitability

The presumption in this study is that changes in import competition generate changes in

future expected profitability. This presumption is supported by a large number of empirical

studies documenting that import competition reduces domestic firms’ profit margin (e.g., Katics

and Petersen, 1994; Levinsohn, 1993). I also show this result in the data.

2.2.1. Measures of import competition and other variables

Following Bertrand (2004), I use import penetration to measure the level of import

competition across industries. In each year, I compute import penetration for each industry as

10
 imports
Import Penetration Index (IPI) =
imports + domestic production

Industries are defined at the three-digit NAICS (Northern American Industry Classification

System) level. I focus on U.S. manufacturing firms (three-digit NAICS varying from 311 to 339).

Import data come from TradeStats Express at the U.S. Government Export Portal. I obtain the

domestic production data from the Bureau of Economic Analysis of the U.S. Department of

Commerce. From the GDP-by-Industry tables in the Bureau’s Annual Industry Accounts section,

I choose the Gross Output series and match it with the three-digit NAICS industry table by

industry names. There are twenty-one industries at the three-digit NAICS level.

I measure financial leverage by both book leverage and market leverage. Book leverage is

the ratio of interest bearing debt (COMPUSTAT data 9 plus data 34) divided by total assets (data

6). Market leverage is the ratio of interest bearing debt divided by the sum of total assets plus

market equity (data 199 times data 25) minus book equity (data 216). The sample contains all

COMPUSTAT manufacturing companies from 1989 to 2004 with non-missing leverage data. I

only include in the sample firms that have non-interrupted financial data. The final sample

contains 29,856 firm-years involving 3,938 firms. Descriptive statistics of these and other

variables used in the paper are provided in Table A1 of Appendix A.

2.2.2. Relation between import competition and domestic profits

When import competition becomes more intense, profit margins decline because the increase

in foreign supply pushes product prices down. To perform a quick check that this result holds in

my sample, I estimate regressions of profit margin on import penetration at the industry and firm

levels. For each three-digit NAICS industry, I define profit margin as the median price-cost

margin across all four-digit SIC industries in the NAICS industry, obtained from U.S. Census

Bureau data. Firm-specific profit margin is calculated from COMPUSTAT data. In the

11
regression model, I control for domestic market concentration (proxied by the Herfindahl

Hirschman Index, or HHI) to focus on the effect of competition coming from imports. The firm-

level regression also includes capital-labor intensity to control for the firm’s technology and

log(market share) to control for its relative position in product market competition. I also

examine whether the average firm’s market share declines when import penetration increases by

regressing log(market share) on import penetration while controlling for market concentration

and capital-labor intensity.

[Table 1 goes about here.]

Table 1 summarizes the regression results. As expected, market concentration is positively

associated with profit margin (Column 1) and market share (Column 3). Column (2) suggests

that firms with more capital-intensive technology tend to have higher profit margins. Firms with

a higher market share also tend to have a higher profit margin. Most important for this paper, the

results unanimously suggest that higher import penetration is associated with lower profit

margins and lower market shares. To the extent that profit margin and market share reflect future

profitability that a firm can expect to sustain, these results support the presumption that increases

in import competition reduce expected profitability.

The coefficients on import penetration are economically significant and comparable in

magnitude to those reported in prior studies.6 For instance, a one standard deviation increase in

import penetration (about 11 percentage points) corresponds to a decline in the industry profit

margin of about 2.6 percentage points, or over 30% of its standard deviation (Column 1). At the

6
Also using samples of U.S. manufacturing industries, Katics and Petersen (1994) report a coefficient of -0.175 and

Pagoulatos and Sorenson (1976) report coefficients of -0.222 to -0.255.

12
firm level, a one standard deviation increase in import penetration is associated with a reduction

of 1.9 percentage points in the firm profit margin or 9% of its standard deviation (Column 2).

I also examine whether predicted profit margin based on import penetration is persistent

through time, since expected profitability should not be entirely transitory. To do so, I

decompose firm profit margin into two orthogonal components based on the regression model in

Column (2) of Table 1: a component predicted by import penetration and related variables (the

competition component) and a residual component. I find that the competition component is

much more persistent over time than the residual component, as the first order autocorrelation of

the competition component (0.97) is higher than that of the residual component (0.69).

2.3. Potential endogeneity and instrumental variables

2.3.1. Instrumental variable identification strategies

To qualify as a valid proxy for expected profitability, import competition should be

exogenous to domestic firms’ profitability and capital structure choices. However, there are

potential endogeneity concerns. For example, an omitted factor could affect both import

competition and firm characteristics including profitability and capital structure. Firm

characteristics could also affect import competition.7 I adopt two empirical strategies to examine

exogenous variations in import competition and identify its causal impacts on capital structure.

First, I use two instrumental variables to capture exogenous variations in import competition.

One of the oldest rationales in the international trade literature is that trade barriers reduce import

competition (e.g., Helpman and Krugman, 1989). I utilize one particularly effective trade barrier,

7
For instance, more profitable industries may be more likely to attract foreign competitors. Capital structure may

also affect import competition by influencing a firm’s competition strategy (e.g., Brander and Lewis, 1986;

Maksimovic, 1988) or its competitiveness in the product market (e.g., Bolton and Scharfstein, 1990; Poitevin, 1989).

13
import tariffs, as the first instrument for import penetration. Tariffs are exogenous to firm level

characteristics in the sense that they do not reflect choices by individual firms.8 I also follow

Revenga (1992) and Bertrand (2004) and use foreign exchange rates as a second instrument for

import penetration. Expressed as the amount of foreign currency per U.S. dollar, the exchange

rate is positively correlated with import penetration. This is because, given a constant offer price

of an imported good in the foreign currency, a higher exchange rate makes the good cheaper in

U.S. dollars, which encourages imports.9 It also satisfies the exclusion restriction since, being a

freely floating currency, the dollar’s exchange rates are primarily determined by macroeconomic

factors that affect its aggregate demand and supply, such as the balances of payments between

the U.S. and its trade partners, interest rates and inflation. Meanwhile, none of these

macroeconomic factors are likely to be caused by individual firm level characteristics.

To construct the industry-level tariff variable, I first take the estimated ad valorem equivalent

of complete Most Favored Nations tariff rate from the John Romalis U.S. Tariff Database 1989-

2001 files10 and match its ten-digit Harmonized Tariff Schedule with NAICS codes using an

8
In a similar vein, Fresard (2010) uses tariffs to generate exogenous variation in product market competition to

study the effect of domestic firms’ cash holdings on their product market share growth. I discuss possible concerns

at the end of this section.

9
Domestic firms may hedge their exposure to the exchange rate risk, which can weaken the link between exchange

rates and import penetration. Despite this, as is shown in the first stage test results presented in Section 3, there

remains a significant correlation between the industry exchange rate and import penetration. This is also in line with

the body of available evidence surveyed in Hafer (1989) which overwhelmingly supports a significant negative

correlation between changes in the dollar exchange rate and U.S. prices. Hafer (1989) reports short-run (long-run)

estimates of domestic price increases of about 2% (5%) for every 10% fall in the dollar exchange rate.
10
A detailed description of this database can be found in Feenstra, Romalis and Schott (2002) and Romalis (2005).

14
industry and product concordance from the U.S. Census Bureau. I then average the tariff rates at

the three-digit NAICS level to obtain industry-level tariff rates.

The industry-level foreign exchange rate variable is constructed from foreign exchange rates,

expressed as the amount of foreign currency per U.S. dollar. First, I transform the raw exchange

rates to real exchange rates using the exchanging countries’ consumer price indices. For each

three-digit NAICS industry, I then compute the source-weighted average of exchange rates

across all countries exporting to the U.S. that take up 2% or more of U.S. total imports in the

base year of 1995. The weights are the share of each exporting country in total U.S. imports in

1995.11 Finally, I divide the resulting exchange rates by 1,000 to obtain the industry exchange

rate index variable expressed in thousands. The exchange rate and consumer price index data are

from the International Financial Statistics of the International Monetary Fund (IMF).

It is worth noting that the identification comes from variations in the instruments rather than

the cross-industry differences or time series changes common to all industries. The main

regression specification, as will be introduced in Section 3, includes both industry fixed effects

and year fixed effects. As such, the identification relies completely on industry-specific changes

11
To check whether the 1995 import shares are appropriate weights for the industry exchange rate calculation, I

examine whether the country shares of imports for each industry change much over time. I find that except for a few

industries such as food (NAICS 311) and printing (NAICS 323), where individual countries like Canada and China

became more important over time, most industries have relatively stable country distribution in the import share.

Moreover, even in these industries with big changes in import shares, the rankings of the countries typically remain

the same. Therefore, it is reasonable to use 1995 import shares to approximate the relative importance of each

country in the industry exchange rate calculation. This is also the approach used in Bertrand (2004). Furthermore, I

also compute the industry exchange rates using actual import shares in each year as the weights. This alternative

exchange rate index has a correlation with my current measure as high as 0.93.

15
in tariffs and foreign exchange rates. Although this specification helps address the concern of

omitted fixed industry factors and common macroeconomic factors, it restricts the power of the

test because both the cross-industry differences and common time series changes are important

for tariffs and exchange rates. For instance, the exchange rate indices of all different industries

will increase if the value of the U.S. dollar increases against all foreign currencies. Although this

exchange rate movement will induce exogenous changes in import competition that constitute a

useful source of variation for identification, the fixed effects specification will not exploit it.

Second, to further pin down the causal impact of import competition on financial leverage, I

take advantage of a quasi-natural experiment that captures an exogenous change in import

competition. From 1995 to 2002, the dollar appreciated substantially, with its real exchange rate

index increasing more than 30%.12 During the same period, imports grew dramatically faster

than exports, which resulted in huge trade deficits. Foreign investments in U.S. assets also grew

at a tremendously greater speed than U.S. investments abroad.

In a nutshell, the dollar’s demand consists of U.S. exports of goods and services and foreign

investments in U.S. assets; and the sum of U.S. imports and U.S. investments abroad constitute

the dollar’s supply. To obtain an exogenous variation in import penetration, it is ideal to identify

changes in the value of the dollar that do not result from a shift in the dollar’s supply function,

because the latter could be caused by a change in the aggregate imports in all industries. This

goal can be achieved by exploiting a shift in the demand function.

The 1995-2002 dollar appreciation serves this purpose well. Obviously, the dollar

appreciation cannot be attributed to a shift in the supply function caused by surging trade deficits

since increasing imports relative to exports imply an increasing supply of the dollar, which

12
The Price-adjusted Broad Dollar Index, Federal Reserve Statistical Release.

16
should have pressured the exchange rate downward. Instead, many authors contend that the

dollar appreciated because of an increasing demand for the dollar by foreign investors of U.S.

assets (Elwell, 2008; Ito, Jansen, Folkerts-Landau, Chen and Cassard, 1996).13 Supportive of this

argument, foreign direct investments and foreign investments in U.S. securities grew by over six

times from 1994 to 2000.14 This is likely the outcome of an accelerated recovery of the U.S.

economy since the early 1990s coupled with concurrent weak economic conditions in foreign

countries including Japan and Germany. Therefore, the dollar appreciation event serves as a

good quasi-natural experiment setting to study the causal impact of import competition on capital

structure.

The test design follows Givoly, Hyan, Ofer and Sarig (1992) and uses cross-sectional

regressions for identification. A cross-sectional test design is appropriate because not all

industries are affected equally by the dollar appreciation. Industries with greater import

penetration are affected more since a greater share of the output market is held by imports and

exposed to foreign exchange rate risk. Consistent with this view, Feinberg (1986, 1989) finds

that import penetration magnifies the pass-through of changes in foreign exchange rates into

domestic prices. Therefore, I expect that the effect of the exchange rate change on leverage

adjustments will be stronger for industries with a greater level of import penetration before the

event. It is also important to note that, since the cross-industry differences are the source of

identification in this analysis and these differences are pre-determined by the level of import

penetration before the event, any remaining endogeneity concern of the dollar appreciation event

should not be too problematic.

13
Also see the annual reports of the Bank for International Settlements, 1997, 2000 and 2001.
14
Table 1, U.S. International Transactions Accounts Data, Bureau of Economic Analysis.

17
2.3.2. Discussion about Tariffs

A potential concern is that increased tariffs are implemented in response to reductions in

profitability. If this effect is substantial, it could undermine the usefulness of using tariffs as an

instrument for import penetration. For example, the impact of tariffs to curb import penetration

could be obscured by the practice that industries with increasing import penetration (and

resulting decreasing profits) lobby for higher tariffs. In Appendix B, I assess the significance of

this problem. Overall, the results suggest a strong impact of tariffs on profitability but not vice

versa.

3. Effects of import competition on financial leverage

3.1. The regression model and the Ordinary Least Squares (OLS) specification

To study the effects of import competition on financial leverage, I use the following linear

regression model:

Leverage it = γ IPI jt −1 + β X it −1 + μ j + vt + ε it (4)

The subscripts i and t represent firm and year, respectively. IPIjt-1 is import penetration in year t-

1 for the industry j in which firm i operates. The regression analysis focuses on the coefficient

for import penetration, γ. Xit-1 is a vector of explanatory variables for leverage motivated by prior

literature, including the market-to-book ratio, profitability, asset tangibility, and firm size (e.g.,

Bradley et al., 1984; Harris and Raviv, 1991; Rajan and Zingales, 1995). Also considered as

controls are the research and development (R&D)-to-sales ratio, the depreciation-to-sales ratio,

and an earnings volatility variable estimated from the past ten years of earnings data. µj is

industry fixed effects, which absorb industry-specific and time-invariant components in financial

leverage and alleviate time-series correlations in leverage due to industry fixed effects (Petersen,

18
2009). vt is year fixed effects, used to control for common time trends in financial leverage

across all industries and firms. εit is a random error term that is assumed to be possibly

heteroskedastic and correlated over time.

Results from OLS regressions on Eq. (4) are summarized in Table 2. I report results from

three regression models that include different sets of control variables. Columns (1)-(3)

correspond to the results for book leverage and Columns (4)-(6) correspond to the results for

market leverage.

[Table 2 goes about here.]

The results show a significantly negative correlation between import penetration and

leverage regardless of which leverage variable is examined and which set of controls are

included in the regression model. The t-statistic for the estimated γ varies from -2.16 to -4.14.

Under the presumption that increases in import competition generate reductions in expected

profitability, these results are consistent with the prediction of tradeoff models that expected

profitability and book leverage are positively related. The results also suggest a positive relation

between expected profitability and market leverage.

Consistent with prior literature, market-to-book and realized profitability are negatively

correlated with leverage, and asset tangibility and firm size are positively correlated with

leverage. The other three control variables, however, are not always important. For example, in

the four specifications including R&D and depreciation-to-sales, R&D is significant in only one

specification and depreciation is significant in two specifications. Neither variable appears to be

an important determinant for market leverage. Finally, earnings volatility is largely insignificant

in determining either book or market leverage. Since the last three control variables are not

significant determinants of leverage in the sample and they also have many missing values and

19
limit the sample size considerably, I only keep market-to-book, profitability, asset tangibility and

firm size in the regression model for the reported tables.

3.2. The Instrumental Variable (IV) specification

To identify the causal effects of import competition on leverage ratios, I estimate IV

regressions using import tariffs and foreign exchange rates to instrument for import penetration.

The IV regressions are conducted in two stages. In the first stage, I regress import penetration on

tariffs, exchange rates, firm controls and fixed effects. In the second stage, I estimate the

regression model in Eq. (4) while replacing import penetration by the predicted value of import

penetration from the first-stage regression. The regression results are summarized in Table 3. In

this and the following sections, I will refer to the IV regressions based on Eq. (4) as the baseline

IV regressions and the results reported herein as the baseline IV regression results.

[Table 3 goes about here.]

The first two columns of Table 3 display the IV estimates of the effects of import penetration

on book leverage and market leverage, respectively. The estimated γ is negative and statistically

significant for both leverage measures. These results are consistent with the OLS results while

supporting a causal interpretation of the impact of import competition on capital structure. The

effects are economically significant as well. A coefficient γ of -0.851 (Column 1) implies that a

one standard deviation (0.11) increase in import penetration leads to a 9 percentage point

reduction in book leverage (-0.851*0.11). The effect on market leverage is somewhat smaller

than that on book leverage (a one standard deviation increase in import penetration leads to an 8

percentage point reduction in market leverage). This is not surprising because firm value also

decreases when import competition intensifies, which offsets some of the reduction in the level

of debt. Noticeably, both estimates are much greater in magnitude than the estimates from the

20
OLS models. To test if the instruments satisfy the irrelevance condition to be valid instruments, I

report p-values of the Hansen’s J-statistic. The p-value of 0.40 and 0.57 suggest that the null

hypothesis cannot be rejected that the instruments are valid, i.e., they are uncorrelated with the

error term and are correctly excluded from the estimated equation.

I also report the first-stage regression result to show supporting evidence that the correlation

condition for the instruments is satisfied. Import penetration is significantly negatively affected

by tariffs and positively affected by exchange rates.15 The coefficients on tariffs and exchange

rates are statistically significant at the 1% level. In addition, the F-statistic is 113.0 for the test of

the null hypothesis that the instruments are jointly zero, which is significantly large and suggests

that the instruments are strong (Stock and Yogo, 2005). This is also confirmed by the Anderson-

Rubin (A-R) χ2 test results at the bottom of Table 3. The A-R test provides statistical inferences

that are robust to weak instruments (Stock, Wright and Yogo, 2002). The results suggest that the

null hypothesis that γ is zero should be rejected at the 1% and 3% levels (p-values are 0.01 and

0.03). Therefore, the IV estimates are robust to concerns regarding weak instruments.

3.3. Robustness

During the sample period, there are many entry and exit activities in the industries. For

example, of the 1,726 firms that appear in the sample in 1990, only 721 firms remain as of 2004,

and another 987 firms that exist in 2004 have entered the sample sometime between 1990 and

15
In unreported tests, I also find the result to hold if only one of the instruments is examined. Moreover, to avoid

spurious correlations from repeated industry observations, I repeat the regressions at the industry level by

eliminating repeated industry observations for import penetration, tariffs and exchange rates (not reported for

brevity). Although power is sacrificed due to a reduction in sample size, the coefficients on the instruments remain

statistically significant.

21
2004. The large number of exits raises the concern of a compositional effect. More specifically,

if highly levered firms exit more often while low-leverage firms survive increased competition,

the average industry leverage will decrease as competition increases. To evaluate this possibility,

I re-estimate the baseline IV regression for a constant composition subsample consisting

exclusively of firms that are observed in all sample years. This and other robustness test results

are summarized in Table 4. For conciseness, I only discuss the results for book leverage (Panel A)

since the results for market leverage are quite similar (Panel B). Column (1) corresponds to the

results in the surviving firm subsample. Compared with the baseline result in Column (1) of

Table 3, the estimated γ is statistically significant and only marginally weaker in the magnitude

(-0.676 compared with -0.851 in Table 3). I therefore conclude that the overall effects of import

competition on leverage cannot be explained by the compositional effect.

[Table 4 goes about here.]

I also collapse the data to the industry level and re-estimate the effects of import competition

on leverage. This robustness test addresses concerns that over-represented industries or outliers

are driving the results. By keeping one observation per industry year, every industry is equally

represented in the test. The results on both leverage ratios (Column 2) show coefficient estimates

for γ that are remarkably similar to those in Table 3, suggesting that the effects are not driven by

over-represented industries or outliers.

Next, since domestic product market competition also affects firms’ expected profitability,

domestic market concentration should have similar effects on capital structure. I use two

measures of domestic market concentration to test this prediction. The first measure is the

Herfindahl Hirschman Index (HHI) and the second is the negative logarithm of the total number

of firms (-Log(N)). Because market concentration varies little over time (Katics and Petersen,

22
1994; Scherer and Ross, 1990), I do not include industry fixed effects in the regressions to retain

sufficient variation for identification. For this reason, the following results should be viewed as

suggestive since one cannot rule out an alternative explanation based on some omitted time-

invariant industry factors. Unreported first-stage regressions show a significantly positive effect

of tariffs and a significantly negative effect of exchange rates on market concentration,

suggesting that stronger trade barriers or a weaker dollar index lead to more concentrated

industries. The second-stage results are reported in Columns (3) and (4) of Table 4. There are

strong positive effects of market concentration on both book and market leverage of firms. Since

high market concentration corresponds to low product market competition, these results are

consistent with negative effects of import competition on leverage ratios.

3.4. The 1995-2002 dollar appreciation

To further alleviate the endogeneity concerns and establish causal effects of import

competition on capital structure, I analyze how leverage ratios change when import penetration

changes as a result of an exogenous U.S. dollar appreciation. As discussed previously, industries

with greater initial import penetration are more sensitive to changes in the value of the dollar.

Therefore, I conduct cross-sectional regressions to examine whether the change in firms’

leverage from 1995 to 2002 is significantly associated with 1995 import penetration across

industries. As controls, I include both the 1995 and the 2002 values of market-to-book,

profitability, asset tangibility and log sales. A firm needs to have non-missing values for leverage

proxies and control variables in both 1995 and 2002 to be included in this test. Therefore, results

from the test are not subject to any compositional effect. Also, since within-firm changes in

leverage are examined, the test design effectively controls for omitted firm fixed effects in

leverage.

23
 [Table 5 goes about here.]

The regression results, as reported in Table 5, again are consistent with the baseline results

that increases in import competition reduce leverage. Both the book and market leverage changes

are significantly negatively correlated with 1995 import penetration, suggesting that firms tend to

reduce their leverage more (or increase their leverage less) when their industry is more exposed

to exchange rate risk.

In a falsification test, I investigate if the above results are specific to the currency shock

period. Evidence consistent with this conjecture will alleviate the concern that the results are due

to an omitted factor, not changes in exchange rates. To this end, I repeat the analysis in the

period of 1989-1995. The exchange rate of the dollar is relatively stable during this period. I find

that none of the results still hold (not reported for brevity). Therefore, results in this subsection

are unlikely to be the outcome of an omitted variable.

3.5. Heterogeneous effects of import competition on leverage by exposure to competition

In this and the next sections I investigate whether the effects of import competition on

leverage differ across firms according to theoretical predictions. This section asks how the

effects depend on firms’ exposure to import competition. If the associations between import

competition and leverage I document are truly attributable to changes in import competition, I

expect such associations to be stronger for firms more exposed to import competition. Evidence

consistent with this will further alleviate the concern that the effects are due to an omitted

variable. The next section instead seeks to further understand the underlying channel through

which import competition affects leverage.

24
 I consider four proxies for a firm’s exposure to import competition.16 Following MacKay and

Phillips (2005), I use the capital-labor ratio to measure production technology and construct the

first proxy, Uniqueness of Operations, to be the absolute deviation of a firm’s capital-labor ratio

from its industry’s median capital-labor ratio. A greater value for this variable suggests that the

firm has more unique production technology than its industry peers; such a firm should be less

adversely affected by intensified import competition. My next proxy for the exposure to

competition is Financial Strength, defined as the cash-to-total asset ratio in excess of its

industry-year average, all divided by its industry-year standard deviation. As Fresard (2010)

argues, a firm’s financial strength can facilitate its market share growth by financing competitive

strategies in the product markets or signaling to do so. Therefore, firms with greater financial

strength should be less adversely affected by increased import competition.17 I also consider a

direct measure of the extent to which a firm is affected by intensified competition, i.e., Change in

Market Share. I define change in market share to be the annual change in a firm’s market share

of sales. I assume that firms with a negative change in market share have been more adversely

affected by increased import competition. Lastly, firms in more competitive industries should be

more strongly affected by intensified import competition, since less monopoly power is in place

to fight against foreign rivals. I define competitive industries to be four-digit SIC industries with

16
Admittedly, the proxies considered here can potentially be endogenous in that they are also directly or indirectly

related to a firm’s financial structure. For instance, high financial strength can coincide with low leverage. However,

I note that such endogeneity should not be too problematic because exogenous shocks to profitability are examined.
17
There may also be a counterbalancing effect due to a potential debt overhang problem. In particular, risky debt

reduces firms’ willingness to take advantage of their cash reserve to invest in competitive strategies when import

competition intensifies because much of the benefit from such investment accrues to the value of debt.

25
an HHI less than 1,000. Concentrated industries are defined as four-digit SIC industries with an

HHI of 1,200 or higher.18

To analyze whether firms that are more subject to import competition indeed make larger

leverage adjustments following import competition changes, I divide sample firms into two

groups based on each of the four proxies and estimate the baseline IV regression in each group. I

then compare the coefficient on import penetration between the two groups using a SUR system

that estimates the two groups jointly.19 The results are summarized in Table 6. For conciseness,

only the estimates of the coefficient γ are reported.

[Table 6 goes about here.]

Across different firm groups, the effects of import competition on book and market leverage

are significantly negative for firms with below-median Uniqueness of Operations, firms with

below-median Financial Strength, firms that experience declines in market share, and firms in

competitive industries. In contrast, for firms with above-median Uniqueness of Operations, firms

with above-median Financial Strength, firms that experience increases in market share, and

firms in concentrated industries, the coefficient γ is smaller in the magnitude (although it is still

negatively signed in most cases) and is not statistically significant. F tests of the equality

between the coefficients in each pair of groups show that the differences in coefficient are also

18
The U.S. Department of Justice classifies unconcentrated industries as having HHI under 1,000, moderately

concentrated industries as having HHI between 1,000 and 1,800, and highly concentrated industries as having HHI

higher than 1,800. I follow the classification for unconcentrated industries (HHI under 1,000) but expand the

coverage of concentrated industries (HHI above 1,200) to avoid having too few industry observations in the

concentrated industry group.

19
Compared with a pooled sample regression that uses a dummy variable to capture the group division, this strategy

is more flexible since it does not require the coefficients on the control variables to be identical between the groups.

26
statistically significant in all but one case (p-value is 0.15 in this case). Overall, the subgroup

comparison results are highly consistent with the prediction that the effects of import

competition on leverage are stronger when firms are more exposed to the adverse effect of

increased competition in the product market. Therefore, the results support the interpretation that

the documented effects on capital structure are indeed coming from changes in import

competition.

3.6. The profitability channel

According to the traditional tradeoff theory, the optimal level of debt decreases with

intensified import competition because expected profitability declines, resulting in increases in

the expected cost of financial distress and decreases in the tax benefit of debt. I evaluate this

channel by identifying subsamples of firms which, based on their ex ante default probabilities or

their tax status, should respond differently to intensified import competition. Results consistent

with predictions of the tradeoff theory (discussed below) will serve as evidence that import

competition affects leverage through the profitability channel.

A firm’s ex ante default probability should be related to the extent that import competition

affects its financial leverage. Specifically, firms with higher ex ante default probabilities should

be more likely to de-lever when competition increases. This is because, under the same negative

shock from import competition, firms with high ex ante default probabilities are more likely to

enter financial distress than firms with low default probabilities. An exception to this regularity,

however, is that firms with extremely high ex ante default probabilities may not de-lever at all

after intensified competition because of inability to repay debt or issue equity.

A firm’s current tax status should also matter for the magnitude of the effects of import

competition on leverage. Specifically, firms with lower marginal tax rates (MTRs) should

27
respond more strongly to changes in import competition. The reason is twofold. First, when a

firm’s expected earnings decline because of intensified import competition, the firm’s tax

liability will more likely decrease to zero if its current MTR (and expected taxable income) is

lower (except when taxable income is already zero). Second, the marginal statutory corporate tax

rate also declines faster with decreases in taxable income at lower income tax brackets.20 For

example, the marginal statutory corporate tax rate declines from 15% to 0 when the taxable

income of a corporation switches from $50 to -$50. By contrast, the rate remains 35% when the

taxable income declines from $18,333,433 to $18,333,333.

Since financial leverage ratios are the variables of interest, I follow MacKie-Mason (1990)

and Graham (1996) and use a modified Altman’s Z-Score that does not explicitly rely on

financial leverage to measure ex ante default probability.21 The modified Altman’s Z-Score is

defined as total assets divided by the sum of 3.3 times earnings before interest and taxes plus

sales plus 1.4 times retained earnings plus 1.2 times working capital. A higher Z-Score suggests

a higher default probability. I adjust a firm’s Z-Score by subtracting from it the industry-year

median Z-Score. To test the above prediction, I divide firms into two groups at the 45th

percentile of the industry-adjusted Z-Score. In view of the above exception to the prediction, I

exclude firms with industry-adjusted Z-Scores in the highest decile from the analysis for a proper

comparison. I then estimate the baseline IV regressions on the effects of import competition on

leverage for each firm group and compare the estimated coefficients on import penetration across

groups using the SUR system.

20
For example, see the Internal Revenue Service’s (IRS) Instructions for Form 1120, U.S. Corporation Income Tax

Return, for the tax rate schedule. The tax rate schedule has remained relatively unchanged since 1986.
21
Results do not change if I use the original Altman’s (1968) Z-Score instead.

28
 [Table 7 goes about here.]

Table 7 summarizes the results from this and the next test. The coefficient γ is significantly

higher in absolute value for the group of firms with higher default probabilities. For instance, in

the book leverage regressions, γ is -0.650 for firms with low Z-Scores and is -1.320 for firms

with high Z-Scores (Columns 1 and 2 of Panel A). The test under the SUR system suggests that

the difference in the coefficient γ between the two groups is statistically significant (p-value is

0.02). The same pattern exists when market leverage is examined in place of book leverage

(Columns 3 and 4). These results are consistent with the prediction that firms with higher ex ante

default probabilities are more likely to de-lever when competition intensifies.

In Panel B, I repeat the above analysis by using lagged industry-median adjusted book

leverage as an alternative proxy for the ex ante default probability since higher leverage is

related to higher default probability. All firms are again divided into two groups by the 45th

percentile of adjusted leverage (firms in the highest decile are excluded). Consistent with Panel

A, I find that the effects of import competition on leverage are stronger for firms with higher

leverage.

I use the marginal tax rate before interest deductions estimated by Blouin, Core and Guay

(2010) to test the prediction about the MTR. In this dataset, the MTR is estimated by forecasting

future taxable income accounting for all tax loss carryforwards and carrybacks over twenty years.

Since the prediction is about the contrast between very low and very high MTRs, I compare

estimates of the coefficient γ between firms in the first and fourth quartiles of the MTR. The

results are reported in Panel C of Table 7. Consistent with the prediction, book and market

leverage ratios are both more strongly affected by import competition for firms with low MTRs

(Columns 1 and 3) than for firms with high MTRs (Columns 2 and 4).

29
4. The mechanics of capital structure adjustment

4.1. Effect of large tariff reductions on capital structure adjustments

I next examine how capital structure adjustments occur when import competition changes.

The previous results establish that both book leverage and market leverage decline with increases

in import competition. For these leverage changes to occur, a firm should either issue new equity

or, alternatively, sell off assets and use the proceeds to pay down debt.

I construct three variables of interest and utilize a change regression specification to perform

this investigation. Net debt issuance is defined as the annual change in debt divided by lagged

assets; net stock issuance is the annual change in outside common equity over lagged assets; and

asset growth is the annual change in assets over lagged assets. The main explanatory variable is a

large tariff reduction dummy, which takes the value of 1 if the annual tariff change is negative

and exceeds fifty basis points in the absolute value and 0 otherwise.22 Lagged annual changes of

firm characteristic variables are included as control variables. I also include lagged leverage in

the model to capture the cumulative impact of past corporate decisions on capital structure. The

regression results are summarized in Panel A of Table 8.

[Table 8 goes about here.]

22
By and large, large tariff increases have opposite effects on leverage adjustments, as one would expect. However,

compared with tariff reductions, tariff increases are much less common. The small number of tariff increasing events

limits the power of a test based on tariff increases. Therefore, I do not include the tariff increase indicator in the

presented model and I believe this does not impair the interpretation of the results on tariff reductions. Moreover, I

repeat the analysis using the annual change in tariff rates directly as the main explanatory variable and the results do

not change in any substantial way. In addition, replacing the tariff change variable with the annual change of import

penetration yields consistent results too, although a causal interpretation would not be warranted in the last case.

30
 The first three columns of Panel A show that net debt issuance is significantly lower, net

stock issuance is significantly higher and assets grow much less when tariffs are reduced than at

other times. Since tariff reductions lead to increased import competition, the results suggest that,

when import competition intensifies and hence firms become over-leveraged, firms issue equity

and sell off assets to pay down debt.23

I also explicitly examine the issuance and retirement decisions in a probit model to provide

further evidence about how firms adjust their capital structure. I first identify four major capital

restructuring activities including debt issuance, debt retirement, stock issuance and stock

repurchase using the issuance and retirement data drawn from the statement of cash flows.24

Following Hovakimian, Opler, and Titman (2001) and Leary and Roberts (2005), I define an

issuance or retirement activity to be the occurrence that the change of debt or outside equity is

more than 5% of the previous year’s total assets (1.25% is used as the cutoff for equity

repurchase). I then construct two conditional issuance/retirement dummy variables that equal 1

for firm-years in which a debt issuance/retirement activity occurs and 0 for firm-years in which a

stock issuance/repurchase activity occurs. While the first four restructuring dummies define

unconditional security issuance or retirement activities, the next two dummy variables capture

23
I also collect several other variables to further explore the detail about asset sales following tariff reductions,

including changes in tangible assets, capital expenditures and acquisitions of other companies. I find that, following

large tariff reductions, tangible assets grow less quickly, and the amounts of both capital expenditures and

acquisitions of other companies decrease. Furthermore, the reduction in tangible assets following tariff reductions is

the result of a reduction in purchases of tangible assets and an increase in sales of tangible assets. These results are

not tabulated for conciseness.

24
All results hold if I define the dummy variables using the balance sheet data instead.

31
the debt versus equity issuance or retirement decision conditional on the circumstance that some

security has to be issued or retired, probably due to changes in cash flows or investment needs.

Columns (4)-(9) summarize the results from the probit regressions. Evidently, when tariffs

decrease, firms are less likely to issue debt (Column 4) and more likely to issue equity (Column

6). To a lesser extent, they are also more likely to retire debt (Column 5) and less likely to

repurchase equity (Column 7). These results are consistent with the idea that, in response to

increases in import competition (in this case due to tariff reductions), firms actively issue equity

and retire debt to adjust to their new target debt ratios. Columns (8) and (9) further show that,

when extra capital is required, firms respond to tariff reductions by issuing equity rather than

debt; when there is redundant capital, firms respond to tariff reductions by retiring debt rather

than equity. These results, again, are in line with adjustments to new optimal leverage following

competition changes.

4.2. Capital structure adjustments during 1995-2002 dollar appreciation

In the dollar appreciation event sample, I also perform cross-sectional regressions to examine

whether, across different industries, firms’ financing activities and changes in assets from 1995

to 2002 are significantly associated with the level of import penetration in 1995.

Similarly as in the tariff change tests, I consider both continuous and binary issuance and

retirement variables. The three continuous variables include net debt issuance, net equity

issuance and the total asset growth over 1995-2002. The six binary issuance variables are

dummies for debt issuance, debt retirement, stock issuance and stock repurchase, as well as an

indicator for issuing debt versus issuing equity and an indicator for retiring debt versus

repurchasing equity, all defined based on activities over 1995-2002.

32
 The regression results are summarized in Panel B of Table 8. The pattern in which capital

structure is adjusted following the currency shock is analogous to that following large tariff

reductions. Net debt issuance and asset growth are negatively correlated while net stock issuance

is positively correlated with 1995 import penetration (Columns 1-3).25 These results suggest that,

following the currency shock, firms issue equity and sell off assets to pay back debt. Finally,

probit regressions of the issuance and retirement dummies show that, unconditionally, firms with

higher exposure to the currency shock tend to issue less debt, issue more equity and repurchase

less equity following the shock (Columns 4-7). Conditional on a financial deficit, more exposed

firms are more likely to issue equity (Column 8); and conditional on a financial surplus, they are

more likely to retire debt (Column 9).

5. Conclusions

Traditional tradeoff theories of capital structure predict that changes in expected profitability

have a positive effect on book leverage and an ambiguous effect on market leverage. However

tests based on realized past profitability often find a negative correlation between profitability

and leverage. By exploiting changes in import competition that generate changes in expected

future profitability, I provide direct evidence for the prediction of traditional tradeoff theories.

Using U.S. manufacturing firm data, I find that, as expected profitability declines with increases

in import competition, firms reduce their leverage by issuing equity and selling assets to repay

debt. By exploiting variations of import penetration driven by changes in import tariffs and

foreign exchange rates and comparing subsamples classified by firms’ exposure to import

25
In the asset growth regression, although the t-statistic on the import penetration coefficient is statistically

insignificant (-1.16), I note that the economic magnitude of the coefficient is comparable to that in the debt or equity

issuance regressions.

33
competition, I confirm that such effects are not manifestations of omitted factors or feedback

effects. Additional tests provide further evidence for the tradeoff theory by showing

heterogeneous effects according to a firm’s ex ante default probability or its tax status.

Admittedly, by reducing profitability, import competition also alleviates Jensen’s (1986) free

cash flow problem. Less debt is needed for disciplinary purposes, which will lead to a lower

target leverage ratio. Unfortunately, the nature of the alternative hypothesis makes it difficult to

be tested in this context.

The paper also supplements the literature about the interactions between capital markets and

product markets by documenting that import competition can affect capital structure. Most prior

empirical work focuses on how capital structure affects corporate behaviors in product market

competition (see, for example, Campello, 2006; Chevalier, 1995; Khanna and Tice, 2005;

Phillips, 1995; Zingales, 1998), while there is relatively little work explicitly examining how

firms account for product market competition in their capital structure decisions.26 Theoretical

models of competition also have opposite implications on the effect of competition on leverage.27

This paper addresses the gap in the literature. Moreover, the empirical framework is useful for

26
A few papers study the impact of product market conditions on capital structure. For example, Banerjee,

Dasgupta, and Kim (2007) find that buyer-supplier relationships affect the leverage of both parties. McKay and

Phillips (2005) find that a firm’s position in the industry influences its capital structure.
27
For instance, Bolton and Scharfstein (1990) argue that financial inflexibility resulting from high leverage may

make firms weak in product market competition. This argument implies that competition should reduce leverage. By

contrast, Brander and Lewis (1986) and Pichler, Stomper and Zulehner (2008) contend that the managerial “risk-

shifting” incentives associated with high leverage will deter entry, which implies that firms may actually take on

more leverage when competition intensifies.

34
further studies on the impacts of product market competition on firms’ financial and investment

decisions.

35
Table 1: Association between Import Penetration and Domestic Profit Margin and Market
Share

This table presents results from regressions of domestic profit margin or log(market share) on import
penetration, market concentration and control variables. Industry-level profit margin in Column (1) is at
the three-digit NAICS industry-level and is defined as the median price-cost margin across all four-digit
SIC industries in the NAICS industry. The price-cost margin for four-digit SIC industries is calculated
from U.S. Census Bureau data as the ratio between Value Added minus Payroll divided by the sum of
Value Added and Total Cost of Materials. Firm-level profit margin in Column (2) is estimated as the sum
of pre-tax income (Compustat data 170), interest expense (data 15) and depreciation and amortization
(data 14), all divided by net sales (data 12). HHI is the Herfindahl Hirschman Index, i.e., the 50 largest
firm concentration ratio as reported in the 1992, 1997 and 2002 Economic Census by U.S. Census Bureau.
Missing values in the four years immediately adjacent to each Census year are back or forward filled by
the value in the Census year. Capital-Labor Intensity is the ratio of total invested capital (data 37) over
number of employees (data 29), winsorized at the 1st and 99th percentiles. Market Share is the ratio of a
firm’s sales to total sales by all domestic firms in the same industry. All regressions control for industry
and year fixed effects. T-statistics based on robust standard errors with industry clusters (in Column 1) or
firm clusters (in Columns 2 and 3) are reported in the parentheses below the coefficients. *, **, and ***
beside the estimated coefficients denote statistical significance at the 10%, 5%, and 1% levels,
respectively.

Dependent variable Profit Margin Log(Market Share)

(1) (2) (3)
Import Penetration -0.236** -0.172** -4.68***
(-2.18) (-1.98) (-4.63)
HHI 0.031** -0.013** 0.331***
(2.18) (-2.55) (3.76)
Capital-Labor Intensity 0.009*** -0.114*
(4.66) (-1.90)
Log(Market Share) 0.050***
(34.78)
Number of Observations 217 22,036 23,466
2
Adjusted R 0.97 0.33 0.34

36
 Table 2: Effects of Import Competition on Financial Leverage, OLS Estimates

This table summarizes results from the OLS regressions for the following model:
Leverage it = γ IPI jt −1 + β X it −1 + μ j + vt + ε it
The subscripts i and t represent firm and year, respectively. IPIit-1 is import penetration in year t-1 for the
industry in which firm i operates. Xit-1 stands for a set of control variables. εit is assumed to be
heteroskedastic and correlated over time. Market-to-Book equals total assets (data 6) plus market equity
(data 199 times data 25) minus book equity (data 216), all divided by total assets. Profitability is
operating income (data 13) divided by previous year total assets. Asset Tangibility is defined as net PP&E
(data 8) divided by total assets. Log Sales is the natural logarithm of net sales (data 12). R&D-to-sales
equals research and development expenditures (data 46) divided by net sales. Depreciation-to-sales equals
depreciation expense (data 14) divided by net sales. Earnings Variance, computed after MacKie-Mason
(1990), is the standard deviation of the first difference of operating income divided by the mean of total
assets, calculated using data from the past ten years. All COMPUSTAT variables are winsorized at the 1st
and 99th percentiles. All regressions control for industry and year fixed effects. T-statistics based on
robust standard errors with firm clusters are reported in the parentheses below the coefficients. *, **, and
*** beside the estimated coefficients denote statistical significance at the 10%, 5%, and 1% levels,
respectively.

Dependent variable Book Leverage Market Leverage

(1) (2) (3) (4) (5) (6)
Import Penetration -0.389*** -0.334** -0.349** -0.380*** -0.396*** -0.453***
(-3.82) (-2.35) (-2.16) (-4.14) (-3.20) (-3.15)
Market-to-Book -0.012*** -0.009*** -0.013*** -0.021*** -0.017*** -0.021***
(-11.97) (-8.78) (-9.01) (-28.05) (-25.14) (-19.30)
Profitability -0.055*** -0.052*** -0.129*** -0.029*** -0.026*** -0.082***
(-9.22) (-7.93) (-8.06) (-9.26) (-8.80) (-10.36)
Asset Tangibility 0.195*** 0.209*** 0.149*** 0.146*** 0.146*** 0.120***
(12.21) (10.46) (5.83) (10.13) (8.23) (5.00)
Log Sales 0.008*** 0.009*** 0.014*** 0.004*** 0.006*** 0.006***
(6.99) (6.76) (8.64) (4.57) (5.00) (4.06)
R&D-to-Sales -0.003** -0.002 0.000 -0.000
(-2.51) (-1.23) (0.10) (-0.48)
Depreciation-to-Sales 0.048*** 0.048* -0.002 0.001
(2.95) (1.72) (-0.24) (0.05)
Earnings Variance 0.071 -0.035
(1.58) (-1.42)
Number of Observations 29,856 21,406 13,379 29,856 21,406 13,379
Adjusted R2 0.13 0.12 0.12 0.24 0.22 0.20

37
 Table 3: Effects of Import Competition on Financial Leverage, IV Estimates

This table summarizes results from the Instrumental Variable (IV) regressions for the following model:
Leverage it = γ IPI jt −1 + β X it −1 + μ j + vt + ε it
The subscripts i and t represent firm and year, respectively. IPIit-1 is import penetration in year t-1 for the
industry in which firm i operates. Xit-1 stands for a set of control variables. εit is assumed to be
heteroskedastic and correlated over time. The instrumental variables are lagged two years. Columns (1)-(2)
present second stage regression results and Column (3) reports first stage regression results using both
tariffs and exchange rates as instruments. The χ2–statistics and p-values are for the Anderson-Rubin Test
of the null hypothesis that γ is zero, and the 95% Confidence Interval is the weak instrument-robust
confidence interval for γ. The F-statistic and p-value in Column (3) are for the test of the null hypothesis
that the coefficients on the IVs are jointly zero. Variable definitions can be found in Table 2. All
regressions control for industry and year fixed effects. T-statistics based on robust standard errors with
firm clusters are reported in the parentheses below the coefficients. *, **, and *** beside the estimated
coefficients denote statistical significance at the 10%, 5%, and 1% levels, respectively.

Second-stage Estimation First-stage Estimation

Book Market Import Penetration
Dependent variable Leverage Leverage
(1) (2) (3)
Import Penetration -0.851*** -0.701*** Tariff -0.453***
(-2.69) (-2.58) (-12.85)
Foreign Exchange 0.140***
Rate (8.79)
Market-to-Book -0.011*** -0.021*** 0.0001**
(-11.04) (-26.83) (2.17)
Profitability -0.051*** -0.026*** 0.000
(-9.18) (-8.17) (0.03)
Asset Tangibility 0.199*** 0.147*** -0.002*
(12.16) (10.02) (-1.82)
Log Sales 0.008*** 0.004*** 0.000
(7.04) (4.43) (0.02)
Number of Observations 26,422 26,422 26,422
Adjusted R2 0.14 0.24 0.98
Hansen J-stat (p-value) 0.40 0.57

Weak instrument robust test of H0: γ=0 Test of H0: IVs jointly equal to 0
χ2-stat 8.53 6.88 F-stat 113.0
p-value 0.01 0.03 p-value 0.00
[-1.579, [-1.326,
95% Confidence Interval
-0.171] -0.055]

38
 Table 4: Effects of Import Competition on Financial Leverage, Robustness Tests

This table summarizes second-stage results from the IV regressions of book leverage (Panel A) or market
leverage (Panel B) on a measure of competition, firm controls and fixed effects. The standard errors are
assumed to be heteroskedastic and correlated over time. The instrumental variables, tariffs and exchange
rates, are lagged two years. Column (1) corresponds to the subsample of surviving firms. Surviving firms
are those surviving throughout the sample period. Column (2) corresponds to the industry-level data
where leverage and other firm variables are averaged in each industry year. Alternative measures of
product market competition are used in place of import penetration in Columns (3) and (4). Log(N) is the
natural logarithm of the number of firms in each industry as reported in the 1992, 1997 and 2002
Economic Census by U.S. Census Bureau. –Log(N) is negative log(N). Missing values in the four years
immediately adjacent to each Census year are back or forward filled by the value in the Census year.
Other variable definitions can be found in Table 2. Regressions in Columns (1) and (2) control for
industry and year fixed effects and Columns (3) and (4) control for year fixed effects. T-statistics based
on robust standard errors with firm clusters (industry clusters for Column 2) are reported in the
parentheses below the coefficients. *, **, and *** beside the estimated coefficients denote statistical
significance at the 10%, 5%, and 1% levels, respectively.

Panel A: Dependent variable = Book Leverage

Survivors Industry-
Only level data Alternative Measures of Competition
(1) (2) (3) (4)
Import Penetration -0.676** -0.714*** HHI 0.331*** -Log(N) 0.121***
(-2.37) (-2.93) (4.16) (3.94)
Market-to-Book -0.020*** -0.013 -0.017*** -0.015***
(-9.73) (-1.57) (-9.78) (-11.31)
Profitability -0.112*** -0.087 -0.056*** -0.034*
(-4.87) (-1.13) (-3.54) (-1.90)
Asset Tangibility 0.190*** -0.041 0.274*** 0.156***
(6.50) (-0.36) (9.26) (4.61)
Log Sales 0.015*** 0.041** 0.003 0.004
(7.48) (2.53) (0.95) (1.48)

Number of Observations 9,373 273 21,306 21,513

2
Adjusted R 0.20 0.84 0.11 0.11
Hansen J-stat (p-value) 0.58 0.84 0.08 0.75

39
 Panel B: Dependent variable = Market Leverage

Survivors Industry-
Only level data Alternative Measures of Competition
(1) (2) (3) (4)
Import Penetration -0.569** -0.550** HHI 0.250*** -Log(N) 0.099***
(-2.19) (-2.31) (3.65) (3.64)
Market-to-Book -0.030*** -0.030*** -0.028*** -0.026***
(-14.43) (-3.51) (-18.92) (-22.75)
Profitability -0.109*** -0.083 -0.029*** -0.009
(-5.75) (-1.16) (-2.65) (-0.62)
Asset Tangibility 0.179*** -0.094 0.236*** 0.140***
(6.10) (-0.69) (9.31) (4.65)
Log Sales 0.005*** 0.035** -0.000 0.000
(2.81) (2.19) (-0.01) (0.05)

Number of Observations 9,373 273 21,306 21,513

Adjusted R2 0.24 0.87 0.19 0.20
Hansen J-stat (p-value) 0.91 0.99 0.00 0.15

40
 Table 5: Effect of 1995-2002 Dollar Appreciation on Capital Structure Adjustments

This table analyzes the leverage responses of firms to the dollar appreciation in 1995-2002 across
different industries. The sample includes all firms with non-missing leverage data between 1995 and 2002.
Book Leverage Change is the 1995-2002 change in book leverage. Market Leverage Change is the 1995-
2002 change in market leverage. T-statistics based on standard errors robust to heteroskedasticity are
presented in the parentheses below the coefficients. *, **, and *** beside the estimated coefficients
denote statistical significance at the 10%, 5%, and 1% levels, respectively.

Book Leverage Market Leverage

Dependent variable Change Change
(1) (2)
1995 Import Penetration -0.179*** -0.126***
(-3.87) (-3.04)
1995 Market-to-Book 0.003 0.008***
(0.86) (3.55)
1995 Profitability 0.092** 0.102***
(2.55) (3.57)
1995 Asset Tangibility -0.073 -0.074*
(-1.45) (-1.73)
1995 Log Sales -0.038*** -0.038***
(-5.46) (-6.43)
2002 Market-to-Book -0.010** -0.035***
(-1.96) (-9.82)
2002 Profitability -0.215*** -0.259***
(-5.20) (-8.75)
2002 Asset Tangibility 0.083* 0.159***
(1.67) (3.86)
2002 Log Sales 0.046*** 0.044***
(6.68) (7.56)
Constant 0.006 0.043**
(0.27) (2.18)
Number of Observations 1,150 1,150
Adjusted R2 0.08 0.16

41
 Table 6: Exposure to Increased Competition and the Effects of Import Competition on
Financial Leverage

This table reports the estimates for import penetration (γ) from baseline IV regressions (Table 3) for
subgroups of firms or industries. Two firm subgroups are formed along one of the three dimensions: for
each industry and year, firms are divided into two groups based on the median Uniqueness of Operations,
the median Change in Market Share, or the median Financial Strength. Two industry subgroups are
formed by domestic industry concentration each year: a Competitive industry group with Herfindahl
Hirschman Index (HHI) less than 1,000 and a Concentrated industry group with HHI greater than 1,200.
Uniqueness of Operations is the absolute deviation of a firm’s capita-labor ratio (data 37 divided by data
29) from its industry-year median capita-labor ratio. Financial Strength is a firm’s cash-to-asset ratio (data
1 divided by data 6) in excess of its industry-year average, all divided by its industry-year standard
deviation. Change in Market Share is the annual change in the share of a firm’s sales in total sales by all
firms in the same industry. Other variable definitions can be found in Table 2. T-statistics are reported in
the parentheses below the coefficients and the numbers of observations used in each of the regressions are
reported below the t-statistics. Columns (3) and (6) report the p-values from F tests of the difference in
the coefficient γ between subgroups. The standard errors for the differences between each pair of Low
and High groups are computed using a SUR system that estimates the two groups jointly. *, **, and ***
denote statistical significance at the 10%, 5%, and 1% levels, respectively.

Dependent variable Book Leverage Market Leverage

Diff. Low Diff. Low

Low High – High Low High – High
(1) (2) (3) (4) (5) (6)
Firm Groups by:
Uniqueness of operations -1.408*** -0.176 0.00 -1.456*** -0.266 0.02
(-3.03) (-0.320) (-3.41) (-0.571)
11,946 11,992 11,946 11,992
Financial strength -1.129*** -0.392 0.09 -0.937*** -0.399 0.15
(-3.06) (-0.96) (-2.71) (-1.22)
12,204 12,050 12,204 12,050
Change in market share -1.328*** -0.603 0.08 -1.152*** -0.400 0.04
(-3.43) (-1.49) (-3.24) (-1.22)
11,541 14,535 11,541 14,535
Industry Groups by:
HHI -1.408*** 0.611 0.03 -1.456*** 0.815 0.01
(-3.03) (0.52) (-3.41) (0.65)
18,402 2,531 18,402 2,531

42
Table 7: Ex ante Default Probability, Tax Status, and the Effects of Import Competition on
Financial Leverage

This table summarizes second-stage results from the baseline IV regressions (Table 3) in subsamples.
Two subsamples are examined based on the industry median-adjusted modified Z-Score, adjusted
leverage and marginal tax rate. Modified Z-score is defined following Graham (1996) and MacKie-Mason
(1990) as total assets divided by the sum of 3.3 times earnings before interest and taxes plus sales plus 1.4
times retained earnings plus 1.2 times working capital. Adjusted leverage is book leverage subtracting the
industry-year median book leverage for each firm. Marginal Tax Rate is the marginal tax rate before
interest deductions from Blouin, Core and Guay (2010). Other variable definitions can be found in Table
2. T-statistics based on robust standard errors with firm clusters are reported in the parentheses below the
coefficients. The last row reports the p-values from F tests of the difference in the coefficient γ between
subgroups. The standard errors for the differences between each pair of groups are computed using a SUR
system that estimates the two groups jointly. *, **, and *** beside the estimated coefficients denote
statistical significance at the 10%, 5%, and 1% levels, respectively.

Panel A: Ex ante Default Probability, Proxied by Z-Score

Dependent variable Book Leverage    Market Leverage

Z-Score Low High Low High
(1) (2) (3) (4)
Import Penetration -0.650* -1.320*** -0.368 -1.166***
(-1.91) (-3.74) (-1.11) (-3.21)
Market-to-Book -0.015*** -0.024*** -0.019*** -0.040***
(-8.56) (-10.15) (-12.15) (-12.21)
Profitability -0.047* 0.130*** -0.123*** 0.030
(-1.93) (4.98) (-6.17) (1.31)
Asset Tangibility 0.128*** 0.064*** 0.086*** 0.074***
(4.91) (2.81) (3.87) (3.13)
Log Sales 0.012*** 0.011*** 0.002* 0.001
(7.13) (6.10) (1.67) (0.37)
Number of Observations 8,636 8,689 8,636 8,689
Adjusted R2 0.16 0.19 0.20 0.24
Comparison between Groups High - Low High - Low
p-value 0.02 0.01

43
 Panel B: Ex ante Default Probability, Proxied by Adjusted Leverage

Dependent variable Book Leverage    Market Leverage

Adjusted Leverage Low High Low High
(1) (2) (3) (4)
Import Penetration -0.569** -1.338*** -0.443** -1.008***
(-2.02) (-4.84) (-2.15) (-3.50)
Market-to-Book 0.001* -0.009*** -0.005*** -0.030***
(1.73) (-7.24) (-16.91) (-21.10)
Profitability -0.025*** -0.050*** -0.009*** -0.021***
(-5.59) (-5.10) (-5.95) (-3.60)
Asset Tangibility 0.109*** 0.033*** 0.072*** 0.029**
(8.75) (2.66) (7.53) (2.20)
Log Sales 0.002 0.001 0.001 -0.004***
(1.40) (0.77) (1.22) (-3.94)
Number of Observations 11,886 11,886 11,886 11,886
Adjusted R2 0.14 0.26 0.25 0.41
Comparison between Groups High - Low High - Low
p-value 0.02 0.05

Panel C: Marginal Tax Rate

Dependent variable Book Leverage    Market Leverage

Marginal Tax Rate Low High Low High
(1) (2) (3) (4)
Import Penetration -4.564** -1.020** -3.748*** -0.802**
(-2.44) (-2.23) (-3.03) (-2.07)
Market-to-Book -0.006*** -0.016*** -0.011*** -0.024***
(-4.34) (-6.47) (-14.54) (-12.12)
Profitability -0.030*** -0.165*** 0.001 -0.152***
(-3.16) (-4.30) (0.16) (-7.20)
Asset Tangibility 0.267*** 0.068** 0.173*** 0.052**
(9.10) (2.48) (7.97) (2.25)
Log Sales 0.004 0.014*** 0.008*** 0.002
(1.34) (5.54) (4.87) (0.88)
Number of Observations 6,083 6,556 6,083 6,556
Adjusted R2 0.04 0.19 0.15 0.28
Comparison between Groups High - Low High - Low
p-value 0.08 0.06

44
 Table 8: Mechanics of Capital Structure Adjustments Following Exogenous Changes in Import Competition

Panel A summarizes results from panel regressions of issuance, retirement and asset change variables on an indicator for large tariff reductions and
control variables, and Panel B reports results from cross-sectional regressions of issuance, retirement and asset change over 1995-2002 on 1995
import penetration and control variables. In Panel A, Net Debt Issuance is defined as the change in debt (data 9+data 34), scaled by lagged total
assets and Net Stock Issuance is the change in outside common equity (data 60-data 36) scaled by lagged total assets. Asset Growth is the change
in total assets scaled by lagged total assets. The debt issuance dummy takes the value of 1 if net debt issuance (data 111-data 114) exceeds 5% of
total assets and 0 otherwise. The debt retirement dummy takes the value of 1 if net debt issuance is negative and exceeds 5% of total assets in the
absolute value and 0 otherwise. The stock issuance dummy takes the value of 1 if net stock issuance (data 108-data 115) exceeds 5% of total assets
and 0 otherwise. The stock repurchase dummy takes the value of 1 if net stock issuance is negative and exceeds one and 1.25% of total assets in
the absolute value and 0 otherwise. The large tariff reduction dummy takes the value of 1 if the annual tariff change is lower than -50 basis points
and 0 otherwise. In Panel B, Net Debt Issuance is defined as the 1995-2002 total net issuances of debt (data 111-data 114), scaled by total assets in
1995, and Net Stock Issuance is the 1995-2002 total net issuances of outside common equity (data 108-data 115) scaled by total assets in 1995.
Asset Growth is total assets in 2002 minus total assets in 1995, both scaled by total assets in 1995. The debt issuance dummy takes the value of 1 if
Net Debt Issuance exceeds 0.2 and 0 otherwise. The debt retirement dummy takes the value of 1 if Net Debt Issuance is lower than -0.1 and 0
otherwise. The stock issuance dummy takes the value of 1 if Net Stock Issuance exceeds 0.2 and 0 otherwise. The stock repurchase dummy takes
the value of 1 if Net Stock Issuance is lower than -0.1 and 0 otherwise. In both panels, “Issuing Debt vs. Stock” is an indicator variable that equals
1 if the debt issuance dummy is 1 and equals 0 if the stock issuance dummy is 1. “Retiring Debt vs. Stock” is an indicator that equals 1 if the debt
retirement dummy is 1 and equals 0 if the stock repurchase dummy is 1. In Panel A, all control variables except lagged book leverage are lagged
annual changes of their corresponding firm characteristics and all regressions control for year fixed effects. T-statistics based on robust standard
errors with firm clusters are reported in the parentheses below the coefficients in Panel A. In Panel B, t-statistics are based on standard errors
robust to heteroskedasticity. *, **, and *** beside the estimated coefficients denote statistical significance at the 10%, 5%, and 1% levels,
respectively.

45
 Panel A: Large Tariff Reductions

OLS Model Marginal Effects of Probit Model

Debt Debt Stock Stock Issuing Retiring
Net Debt Net Stock Asset Issuance Retirement Issuance Repurchase Debt vs. Debt vs.
Dependent variable Issuance Issuance Growth Dummy Dummy Dummy Dummy Stock Stock
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Large Tariff Reduction Dummy -0.018*** 0.034*** -0.024*** -0.027*** 0.010 0.038*** -0.014* -0.127*** 0.049*
(-5.19) (4.42) (-2.71) (-3.38) (1.26) (4.41) (-1.65) (-5.24) (1.74)
Market-to-Book Change 0.003*** 0.044*** 0.054*** 0.004** 0.001 0.017*** -0.001 -0.022*** 0.006
(4.16) (13.21) (17.07) (2.55) (0.78) (8.92) (-0.95) (-5.69) (0.76)
Profitability Change 0.004 0.057*** -0.001 -0.002 0.022*** 0.045*** -0.015** -0.089*** 0.149***
(0.73) (3.06) (-0.05) (-0.20) (3.04) (4.57) (-2.02) (-4.23) (2.97)
Asset Tangibility Change 0.142*** 0.236*** 0.120** 0.309*** -0.124*** 0.104** -0.156*** 0.306*** -0.185
(6.96) (4.86) (2.24) (6.58) (-3.72) (2.43) (-4.23) (2.81) (-1.21)
Log Sales Change 0.018*** 0.063*** 0.104*** 0.035*** -0.013*** 0.050*** -0.028*** -0.059*** -0.015
(5.28) (5.87) (8.97) (5.44) (-2.76) (6.97) (-5.13) (-4.34) (-0.55)
Lagged Leverage -0.107*** -0.170*** -0.271*** 0.214*** 0.438*** -0.075*** -0.260*** 0.577*** 1.787***
(-16.36) (-9.68) (-17.19) (12.81) (30.63) (-3.95) (-11.18) (10.32) (23.07)
Number of Observations 22,307 22,307 22,307 20,863 20,863 20,243 20,243 4,796 5,017
Adjusted R2 0.043 0.081 0.083 0.024 0.108 0.033 0.047 0.063 0.267

46
 Panel B: 1995-2002 Dollar Appreciation

OLS Model Marginal Effects of Probit Model

Debt Debt Stock Stock Issuing Retiring
Net Debt Net Stock Asset Issuance Retirement Issuance Repurchase Debt vs. Debt vs.
Dependent variable Issuance Issuance Growth Dummy Dummy Dummy Dummy Stock Stock
(1) (2) (3) (4) (5) (6) (7) (8) (9)
1995 Import Penetration -0.438*** 0.318* -0.527 -0.516*** 0.074 0.235** -0.306** -1.080*** 0.472**
(-4.16) (1.85) (-1.16) (-3.44) (0.89) (2.04) (-2.56) (-3.89) (2.15)
1995 Market-to-Book -0.001 0.090*** 0.189*** -0.002 -0.006 0.022*** 0.010 -0.012 -0.015
(-0.16) (4.48) (3.65) (-0.17) (-0.92) (2.88) (1.24) (-0.74) (-0.77)
1995 Profitability 0.182* -0.840*** 1.865*** 0.217** -0.023 0.056 0.358*** -0.198 -0.637***
(1.78) (-4.70) (4.47) (2.22) (-0.43) (0.75) (3.85) (-1.26) (-3.16)
1995 Asset Tangibility 0.307** 0.304 2.534*** 0.288** -0.006 0.203 -0.358*** -0.184 0.492**
(2.56) (1.54) (3.96) (2.10) (-0.08) (1.55) (-2.78) (-0.68) (2.00)
1995 Log Sales -0.227*** -0.312*** -1.786*** -0.204*** 0.015 -0.171*** 0.100*** 0.109*** -0.070*
(-9.42) (-8.37) (-13.42) (-7.81) (1.36) (-7.71) (5.78) (2.72) (-1.88)
2002 Market-to-Book -0.053*** -0.040 -0.155** -0.053*** -0.010 0.002 0.046*** -0.128*** -0.080
(-4.38) (-1.13) (-2.50) (-3.09) (-0.66) (0.06) (2.71) (-3.29) (-1.59)
2002 Profitability -0.559*** -1.452*** -2.381*** -0.421*** 0.273*** -0.888*** 0.991*** 1.510*** -0.473*
(-6.14) (-5.68) (-5.44) (-3.38) (3.00) (-5.31) (7.82) (5.06) (-1.69)
2002 Asset Tangibility -0.295** -0.298 -3.666*** 0.008 0.007 -0.264** 0.020 0.606** 0.050
(-2.38) (-1.45) (-6.00) (0.06) (0.09) (-2.19) (0.16) (2.26) (0.18)
2002 Log Sales 0.243*** 0.276*** 1.772*** 0.233*** -0.041*** 0.134*** -0.080*** 0.011 -0.010
(9.74) (7.52) (12.75) (8.33) (-3.91) (6.18) (-4.73) (0.29) (-0.28)
Constant 0.225*** 0.333*** 0.837***
(4.20) (3.83) (3.27)
Number of Observations 1,150 1,150 1,150 1,150 1,150 1,150 1,150 449 359
Adjusted R2 0.204 0.421 0.508 0.130 0.055 0.258 0.185 0.407 0.236

47
 Appendix A

Table A1: Summary Statistics

This table summarizes the variables used in the paper.

Panel A. Variables in the main analysis

Number of Standard
Variable observations Mean deviation Median
Leverage Proxies:
Book Leverage 29,856 0.20 0.20 0.17
Market Leverage 29,856 0.16 0.16 0.10
Competition Proxies:
Import Penetration 29,856 0.20 0.11 0.20
Tariff 26,344 0.044 0.026 0.042
Foreign Exchange Rate (1,000) 29,856 0.13 0.10 0.11
Control Variables:
Market-to-Book 29,856 2.1 2.1 1.5
Operating Profitability 29,856 0.05 0.40 0.13
Asset Tangibility 29,856 0.25 0.17 0.21
Log Sales 29,856 4.6 2.4 4.6
R&D to Sales 21,406 0.79 4.17 0.05
Depreciation to Sales 29,856 0.09 0.26 0.04
Earnings Variance 18,978 0.029 0.071 0.007

Panel B. Variables in the analysis of the 1995-2002 dollar appreciation event

Number of Standard
Mean Median
Variable observations deviation
Leverage Proxies:
Book Leverage Change 1,150 0.02 0.17 0.00
Market Leverage Change 1,150 0.05 0.15 0.02
Net Debt Issuance 1,150 0.23 0.46 0.07
Net Equity Issuance 1,150 0.24 0.80 0.00
Asset Growth 1,150 1.46 2.36 0.69
Debt Issuance Dummy 1,150 0.35 0.48 0.00
Debt Retirement Dummy 1,150 0.11 0.32 0.00
Stock Issuance Dummy 1,150 0.24 0.43 0.00
Stock Repurchase Dummy 1,150 0.23 0.42 0.00
Issuing Debt vs. Stock 449 0.64 0.48 1.00
Retiring Debt vs. Stock 359 0.31 0.46 0.00

48
Competition Proxy:
Import Penetration, 1995 1,150 0.19 0.11 0.20

Control Variables:
Market-to-Book, 1995 1,150 2.3 1.9 1.7
Operating Profitability, 1995 1,150 0.15 0.20 0.17
Asset Tangibility, 1995 1,150 0.26 0.17 0.23
Log Sales, 1995 1,150 5.0 2.2 5.0
Market-to-Book, 2002 1,150 1.5 1.0 1.2
Operating Profitability, 2002 1,150 0.08 0.17 0.10
Asset Tangibility, 2002 1,150 0.25 0.16 0.21
Log Sales, 2002 1,150 5.4 2.3 5.4

Panel C. Variables in the analysis of large tariff reductions

Number of Standard
Mean Median
Variable observations deviation
Leverage Proxies:
Net Debt Issuance 29,851 0.03 0.15 0.00
Net Equity Issuance 29,716 0.12 0.37 0.01
Asset Growth 27,543 0.12 0.39 0.05
Debt Issuance Dummy 27,946 0.16 0.37 0.00
Debt Retirement Dummy 27,946 0.12 0.32 0.00
Stock Issuance Dummy 26,848 0.14 0.34 0.00
Stock Repurchase Dummy 26,848 0.15 0.36 0.00
Issuing Debt vs. Stock 6,389 0.55 0.50 1.00
Retiring Debt vs. Stock 6,431 0.44 0.50 0.00
Competition Proxy:
Large Tariff Reduction Dummy 24,447 0.15 0.36 0.00
Control Variables:
Market-to-Book Change 27,880 -0.1 1.6 0.0
Profitability Change 28,409 0.01 0.32 0.00
Asset Tangibility Change 29,853 -0.003 0.068 -0.002
Log Sales Change 29,638 0.1 0.5 0.1

49
 Appendix B: Relation between Tariffs and Profitability

A potential problem with using tariffs to instrument for import competition is that tariff

increases can be implemented in response to profitability declines since industries with declining

returns will lobby for higher tariffs. Similarly, these industries should also lobby against tariff

reductions. This theory predicts that firms with greater profitability reductions should be more

likely to experience tariff increases (Prediction 1) and be less likely to experience tariff

reductions (Prediction 2).

To test these predictions, I sort all firms into quartiles by their profitability change in the past

two years. I then compare the likelihood that large tariff reductions or increases (tariff changes

greater than 50 basis points in the absolute value) occur in the following years across the firm

quartiles. The results are summarized in Table A2.

The table provides little evidence for these predictions. Inconsistent with Prediction 1, the

likelihood of having tariff increases is almost constant across the four profitability change

quartiles (Panel A). In contrast to Prediction 2, the likelihood of having tariff reductions is higher

in Q1 than in Q2 and Q3 (Panel B).

An alternative theory is that industries with relatively low profitability pursue higher tariffs.

This alternative theory predicts that firms in lower profitability quartiles should be more likely to

experience tariff increases (Prediction 3) and be less likely to experience tariff reductions

(Prediction 4). Table A3 reports the fraction of firms that experience at least one large tariff

reduction/increase in one year, two years, three years, or four years by quartiles of their

profitability this year. There is some weak evidence for Prediction 3 in Panel A. The lowest

profitability quartile (Q1) sees a one to two percentage point higher likelihood of large tariff

increases than other quartiles. This magnitude is fairly small. Besides, there is no monotonic

50
pattern in likelihood of tariff increases across four profitability quartiles. The results in Panel B

are in sharp contrast to Prediction 4; firms in Q1 experience a significantly higher likelihood of

large tariff reductions.

Overall, I find no clear evidence in the data that decreasing profitability or low profitability is

related to a higher likelihood of tariff increases or a lower likelihood of tariff reductions. This is

consistent with Fresard (2010) who documents no systematic differences in firm characteristics

between industries experiencing tariff reductions and those not.

To further illustrate the relation between tariff changes and profitability, I also examine

average profitability in the five years around large tariff changes using graphs (Fig. A1). It is

noteworthy that there is no obvious profitability change before either tariff reductions or tariff

increases, consistent with the results in Table A2. Moreover, I find that profitability declines

greatly, from over 8% to around 3%, in the year of and the two years following tariff reduction.

This is consistent with the idea that tariff reductions lead to lower profits. Profitability also

increases after tariff increases, but to a much lesser extent.28 Overall, the results suggest tariff

changes have significant impacts on firm profitability but not vice versa.

28
The standard errors of the average profitability are relatively large for tariff increasing events, which makes the

profitability change statistically insignificant. The reason lies in the small number of tariff increasing events (there

are only nine large tariff increases compared to thirty-one large tariff reductions).

51
 Table A2: Likelihood of Large Tariff Changes by Profitability Change Quartiles
This table reports the fraction of firms that experience one or more large tariff reductions/increases in one
year, two years, three years, or four years by quartiles of their profitability change in the past two years.
Large tariff reductions/increases are defined as a tariff reduction/increase of more than 50 basis points.
There are 9 large tariff increases and 31 large tariff reductions in the sample.

Panel A. Tariff Increases

Mean % firms experiencing large tariff increase in
Quartiles of profitability Profitability
change in past two years change one year two years three years four years
Q1 -0.24 3% 3% 3% 3%
Q2 -0.04 3% 4% 4% 4%
Q3 0.02 3% 3% 4% 4%
Q4 0.30 3% 3% 3% 5%
Panel B. Tariff Reductions
Mean % firms experiencing large tariff reduction in
Quartiles of profitability Profitability
change in past two years change one year two years three years four years
Q1 -0.24 19% 18% 18% 21%
Q2 -0.04 13% 13% 16% 18%
Q3 0.02 15% 17% 17% 19%
Q4 0.30 18% 19% 21% 23%

Table A3: Likelihood of Large Tariff Changes by Profitability Quartiles

This table reports the fraction of firms that experience one or more large tariff reductions/increases in one
year, two years, three years, or four years by quartiles of their profitability this year.

Panel A. Tariff Increases

Quartiles of profitability this Mean % firms experiencing large tariff increase in
year Profitability one year two years three years four years
Q1 -0.28 4% 4% 5% 5%
Q2 0.08 3% 3% 3% 3%
Q3 0.16 3% 3% 4% 4%
Q4 0.29 3% 3% 4% 4%
Panel B. Tariff Reductions
Quartiles of profitability this Mean % firms experiencing large tariff reduction in
year Profitability one year two years three years four years
Q1 -0.28 20% 21% 21% 23%
Q2 0.08 14% 16% 17% 19%
Q3 0.16 14% 15% 16% 18%
Q4 0.29 18% 19% 20% 21%

52
 Figure A1: Profitability around Import Tariff Changes

The following graphs show the average profitability of firms (the solid line) in the two years before,
the year of and the two years after import tariff changes. The dash lines represent the average profitability
plus or minus one standard error of the average profitability, computed as one standard deviation divided
by the square root of the number of observations.

Figure A1a: Profitability around Import Tariff Reductions

0.09
0.08
0.07
0.06
Profitability

0.05
0.04
0.03
0.02
0.01
0
‐2 ‐1 0 1 2
years before and after import tariff reductions

Figure A1b: Profitability around Import Tariff Increases

0.09
0.08
0.07
0.06
Profitability

0.05
0.04
0.03
0.02
0.01
0
‐2 ‐1 0 1 2
years before and after import tariff increases

53
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