Financial Leverage and Expected Stock Returns: Evidence from Pure Exchange Offers
Arthur G. Korteweg
Stanford Graduate School of Business
September 6, 2004
This paper tests Modigliani-Miller proposition 2, which states that expected stock returns should increase in financial leverage. Past cross-sectional studies have uncovered evidence contradicting this proposition. We employ a time-series approach which allows us to better control for the firm's unlevered (business) risk i.e. asset betas. In addition, we allow for time-varying (non-zero) debt betas, use different measures of financial leverage and consider the Fama-French 3-factor model as an alternative to the CAPM. Using a sample of pure capital structure changes in the form of exchange offers, we find that implied asset betas change after the offer has closed and by too much to be consistent with proposition 2. We conclude that the factor loadings of highly levered companies are too low and find some supporting evidence from a simple trading strategy involving firms with extreme levels of financial leverage.
Number of Pages in PDF File: 46
Keywords: Financial leverage, expected returns, exchange offers, levered beta, asset beta, capital structure, modigliani-miller, market efficiency, convertible arbitrage, capital structure arbitrage
JEL Classification: G12, G14, G32working papers series
Date posted: October 4, 2004
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