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Financial Distress and the Cross Section of Equity ReturnsLorenzo GarlappiUniversity of British Columbia - Sauder School of Business Hong YanUniversity of South Carolina; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) June 25, 2010 Journal of Finance, Forthcoming Abstract: 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, G33 working papers seriesDate posted: March 21, 2007 ; Last revised: June 25, 2010Suggested CitationContact Information
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