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Financial leverage, corporate investment, and stock returns

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  • Ali K. Ozdagli
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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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    File URL: http://www.bostonfed.org/economic/wp/wp2009/wp0913.htm
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 09-13.

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    Date of creation: 2009
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    Handle: RePEc:fip:fedbwp:09-13

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    Keywords: Corporations - Finance ; Stocks - Rate of return;

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    1. Lettau, Martin & Wachter, Jessica, 2005. "Why is Long-Horizon Equity Less Risky? A Duration-based Explanation of the Value Premium," CEPR Discussion Papers 4921, C.E.P.R. Discussion Papers.
    2. 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, 09.
    3. Abel, Andrew B & Eberly, Janice C, 1996. "Optimal Investment with Costly Reversibility," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 581-93, October.
    4. Robert E. Hall, 2004. "Measuring Factor Adjustment Costs," The Quarterly Journal of Economics, MIT Press, vol. 119(3), pages 899-927, August.
    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, 02.
    6. Jonathan Berk & Richard C. Green & Vasant Naik, 1998. "Optimal Investment, Growth Options, and Security Returns," NBER Working Papers 6627, National Bureau of Economic Research, Inc.
    7. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
    8. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
    9. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, 02.
    10. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
    11. Murray Carlson & Adlai Fisher & Ron Giammarino, 2004. "Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns," Journal of Finance, American Finance Association, vol. 59(6), pages 2577-2603, December.
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