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Mediating role of profitability relating financial leverage and stock returns

Author

Listed:
  • Gaurav Singh Chauhan

Abstract

Purpose - This paper aims to highlight firms' profitability as an alternative channel by which changes in leverage could affect stock returns in an imperfect market setting. The author also analytically argues that the benefits of debt, if any, may accrue beyond the usual tax benefit channel. Design/methodology/approach - The author used multivariate regression models based on firms' characteristics and the models' changes along with a two-stage least-square (2SLS) type procedure to estimate the impact of leverage changes on stock returns. The author controls for the varying arbitrage risk that is measured by forecasted idiosyncratic volatility of stock prices and overcome simultaneous or endogenous determination by using inter-temporal non-synchronous variation in leverage and control variables. Findings - The author finds that increase in leverage increase (decrease) stock returns for firms with the gross operating profitability higher (lower) than the cost of debt. The author also finds that the variation in arbitrage risk does not substitute for the primary effect of leverage changes on stock returns. Research limitations/implications - The author's findings provide tacit support to the recent literature attempting to resolve the empirically puzzling pattern of the negative relationship between profitability and leverage. The findings suggest inclusion of profitability as a crucial asset-pricing factor in the contemporary empirical models. Practical implications - The non-trivial role of profitability in determining the effect of leverage on firms' stock returns that may be useful to managers, credit analysts and policy makers to assess the impact of net profitability on any change in leverage and its ensuing consequences on firms' value. Originality/value - The paper develops analytical insights into the marginal role of profitability in influencing the relationship between firms' financing decisions and firms' stock returns beyond the conventional mechanisms of tax benefits, bankruptcy costs and information asymmetry.

Suggested Citation

  • Gaurav Singh Chauhan, 2023. "Mediating role of profitability relating financial leverage and stock returns," International Journal of Emerging Markets, Emerald Group Publishing Limited, vol. 19(10), pages 3459-3482, January.
  • Handle: RePEc:eme:ijoemp:ijoem-04-2022-0557
    DOI: 10.1108/IJOEM-04-2022-0557
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    More about this item

    Keywords

    Leverage changes; Profitability; Value; Market imperfections; Arbitrage risk; G32; G30;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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