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Financial leverage, corporate investment, and stock returns

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Abstract

This paper presents a dynamic model of the firm with risk-free debt contracts, investment irreversibility, and debt restructuring costs. The model fits several stylized facts of corporate finance and asset pricing: First, book leverage is constant across different book-to-market portfolios, whereas market leverage differs significantly. Second, changes in market leverage are mainly caused by changes in stock prices rather than by changes in debt. Third, when the model is calibrated to fit the cross-sectional distribution of book-to-market ratios, it explains the return differences across different firms. The model also shows that investment irreversibility alone cannot generate the cross-sectional patterns observed in stock returns and that leverage is the main source of the value premium.

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  • Ali Ozdagli, 2009. "Financial leverage, corporate investment, and stock returns," Working Papers 09-13, Federal Reserve Bank of Boston.
    • Handle: RePEc:fip:fedbwp:09-13
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    References listed on IDEAS

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    1. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
    2. repec:bla:jfinan:v:59:y:2004:i:6:p:2577-2603 is not listed on IDEAS
    3. Martin Lettau & Jessica A. Wachter, 2007. "Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium," Journal of Finance, American Finance Association, vol. 62(1), pages 55-92, February.
    4. Robert E. Hall, 2004. "Measuring Factor Adjustment Costs," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 119(3), pages 899-927.
    5. Ilan Cooper, 2006. "Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment," Journal of Finance, American Finance Association, vol. 61(1), pages 139-170, February.
    6. Andrew B. Abel & Janice C. Eberly, 1996. "Optimal Investment with Costly Reversibility," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 63(4), pages 581-593.
    7. Jonathan B. Berk & Richard C. Green & Vasant Naik, 1999. "Optimal Investment, Growth Options, and Security Returns," Journal of Finance, American Finance Association, vol. 54(5), pages 1553-1607, October.
    8. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, February.
    9. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    10. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    11. repec:bla:jfinan:v:44:y:1989:i:1:p:19-40 is not listed on IDEAS
    12. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
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    Keywords

    Corporations - Finance; Stocks - Rate of return;

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