Financial Leverage, Corporate Investment, and Stock Returns

This article rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model analytically shows that tax deductibility of interest payments increases effe...

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Veröffentlicht in:The Review of financial studies 2012-04, Vol.25 (4), p.1033-1069
1. Verfasser: Ozdagli, Ali K.
Format: Artikel
Sprache:eng
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Zusammenfassung:This article rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model analytically shows that tax deductibility of interest payments increases effective investment irreversibility and that investment irreversibility weakens the relation between book-to-market values and returns. This provides a clear and novel mechanism showing how financial leverage affects stock returns beyond the standard Modigliani-Miller paradigm. The article argues that market leverage, rather than operating leverage or investment irreversibility, explains a major portion of the value premium. Empirical evidence supports this argument.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhr145