Financial Distress and the Cross Section of Equity Returns
University of British Columbia - Sauder School of Business
University of South Carolina; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)
June 25, 2010
Journal of Finance, Forthcoming
We explicitly consider financial leverage in a simple equity valuation model and study the cross-sectional implications of potential shareholder recovery upon resolution of financial distress. We show that our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book-to-market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump-shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.
Number of Pages in PDF File: 74
Keywords: Financial distress, value premium, momentum, growth options
JEL Classification: G12, G14, G33working papers series
Date posted: March 21, 2007 ; Last revised: June 25, 2010
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