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Financial leverage, corporate investment, and stock returns


  • Ali K. Ozdagli


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 K. 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

    1. Andrew B. Abel & Janice C. Eberly, 1996. "Optimal Investment with Costly Reversibility," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 581-593.
    2. 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.
    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. 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.
    5. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
    6. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, February.
    7. 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.
    8. 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.
    9. Robert E. Hall, 2004. "Measuring Factor Adjustment Costs," The Quarterly Journal of Economics, Oxford University Press, vol. 119(3), pages 899-927.
    10. 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.
    11. 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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    Cited by:

    1. Berardino Palazzo, 2013. "Net leverage, risk, and credit spreads," 2013 Meeting Papers 436, Society for Economic Dynamics.
    2. Fukuta, Yuichi & Yamane, Akiko, 2015. "Value premium and implied equity duration in the Japanese stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 39(C), pages 102-121.
    3. Shu Hui Lan & Jia Yi Cheng & Sheng Guo, 2016. "How to Build up the Loan - Evaluation System toward Small and Medium Enterprises between Taiwan and China’s Commercial Banks? The Application for Multi Criteria Decision Making," International Business Research, Canadian Center of Science and Education, vol. 9(3), pages 121-142, March.
    4. Dendramis, Yiannis & Kapetanios, George & Tzavalis, Elias, 2015. "Shifts in volatility driven by large stock market shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 55(C), pages 130-147.
    5. Ozdagli, Ali K., 2014. "Financial frictions and the reaction of stock prices to monetary policy shocks," Working Papers 14-6, Federal Reserve Bank of Boston.
    6. Cao, Viet Nga, 2015. "What explains the value premium? The case of adjustment costs, operating leverage and financial leverage," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 350-366.
    7. Tao Shen, 2017. "Credit spreads and investment opportunities," Review of Quantitative Finance and Accounting, Springer, vol. 48(1), pages 117-152, January.
    8. Rath, Subhrendu & Durand, Robert B., 2015. "Decomposing the size, value and momentum premia of the Fama–French–Carhart four-factor model," Economics Letters, Elsevier, vol. 132(C), pages 139-141.
    9. repec:oup:restud:v:82:y:2015:i:4:p:1449-1482. is not listed on IDEAS

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    Corporations - Finance ; Stocks - Rate of return;

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