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Inflexibility and Stock Returns

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  • Lifeng Gu
  • Dirk Hackbarth
  • Tim Johnson

Abstract

Investment-based asset pricing research highlights the role of irreversibility as a determinant of firms' risk and expected return. In a neoclassical model of a firm with costly scale adjustment options, we show that the effect of scale flexibility (i.e., contraction and expansion options) is to determine the relation between risk and operating leverage: risk increases with operating leverage for inflexible firms, but decreases for flexible firms. Guided by theory, we construct easily reproducible proxies for inflexibility and operating leverage. Empirical tests provide support for the predicted interaction of these characteristics in stock returns and risk. Received October 28, 2015; editorial decision May 1, 2017 by Editor Andrew Karolyi.

Suggested Citation

  • Lifeng Gu & Dirk Hackbarth & Tim Johnson, 2018. "Inflexibility and Stock Returns," The Review of Financial Studies, Society for Financial Studies, vol. 31(1), pages 278-321.
    • Handle: RePEc:oup:rfinst:v:31:y:2018:i:1:p:278-321.
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    More about this item

    JEL classification:

    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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