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Leverage, Excess Leverage and Future Stock Returns
Judson A. Caskey University of California at Los Angeles - Anderson School of Management John S. Hughes University of California at Los Angeles Jing Liu University of California at Los Angeles May 28, 2008 Abstract: We examine the relation between leverage and future stock returns while simultaneously considering the dynamic nature of firm's leverage. Using Graham's (2000) kink measure as a proxy for excess leverage, we find supportive evidence that firm's leverage can be characterized by a partial adjustment model. Excess leverage predicts not only future changes in leverage, but also other fundamentals such as investment and profitability. The market does not seem to fully understand the information contained in excess leverage about future fundamentals (especially investments), and under-levered firms earn superior risk adjusted returns through unexpected growth. The anomalous finding by Penman, Richardson and Tuna (2007), that the relation between leverage and future returns is negative, is subsumed by the negative relation between excess leverage and future returns.
Keywords: leverage, excess leverage, stock returns, capital structure, market efficiency JEL Classifications: G12, G14, G32 Working Paper SeriesDate posted: May 28, 2008 ; Last revised: June 11, 2008Suggested CitationContact Information
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