Asset Pricing Implications of Non-Convex Adjustment Costs and Irreversibility of Investment
BI Norwegian Business School; Tel Aviv University, Graduate School of Business Administration
AFA 2004 San Diego Meetings; EFA 2003 Annual Conference Paper No. 863
This paper derives a real options model that accounts for the value premium in stock returns. If real investment is largely irreversible, the book value of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to easily expand production in response to positive aggregate shocks. Thus, returns to equity holders of a high book-to-market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium.
Number of Pages in PDF File: 44
Date posted: July 25, 2003
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