Do temporary changes in earnings caused by mean reversion affect firms’ refinancing decisions?

We develop a dynamic two‐stage trade‐off model with refinancing when earnings are mean reverting. Our model predicts a negative relation between profitability and leverage at refinancing due to conservative debt increases. With multiple rounds of refinancing, the leverage–profitability relation may turn positive when firms have substantial debt tax shields. Our empirical analysis of US firms reveals that firms with moderate incentives to shield tax benefits with debt internalize the temporary increase in earnings caused by mean reversion at refinancing. However, firms with strong incentives to shield tax benefits take on excessive debt despite the temporary increases in profitability