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Reassessing the effect of growth options on leverage

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  • Ogden, Joseph P.
  • Wu, Shanhong

Abstract

Results of empirical studies of the trade-off theory of capital structure indicate that an important, stable factor is missing from traditional leverage regression models. Our review of theory leads us to the hypothesis that the missing factor is related to profitable growth options (GOs). Specifically, the relationship between optimal leverage and the market-to-book assets ratio (MB), a measure of GOs, is negative and highly convex. In tests of static trade-off theory, we find that a convex (inverse exponential) transformation of MB substantially increases adjusted R2 in leverage regressions, and partially subsumes the explanatory power of median industry leverage. Using the transformed MB variable also yields stronger results in tests of dynamic trade-off theory, including analyses of leverage evolution, speed of adjustment, and external financing activity.

Suggested Citation

  • Ogden, Joseph P. & Wu, Shanhong, 2013. "Reassessing the effect of growth options on leverage," Journal of Corporate Finance, Elsevier, vol. 23(C), pages 182-195.
    • Handle: RePEc:eee:corfin:v:23:y:2013:i:c:p:182-195
    DOI: 10.1016/j.jcorpfin.2013.08.008
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    3. Lin, Qi, 2015. "Growth options effect on leverage: Evidence from China," Pacific-Basin Finance Journal, Elsevier, vol. 34(C), pages 152-168.
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    More about this item

    Keywords

    Capital structure; Leverage; Trade-off theory; Growth options; Market-to-book;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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