Leverage Change, Debt Capacity, and Stock Prices
42 Pages Posted: 7 Mar 2008
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Leverage Change, Debt Capacity, and Stock Prices
Date Written: March 3, 2008
Abstract
We document a significant, negative effect of quarterly change in a firm's leverage ratio on its monthly stock returns for the next quarter. This effect cannot be explained by popular asset pricing factors and is robust after controlling for a number of firm characteristics. We find that the negative effect is stronger for firms with limited debt capacity. Moreover, firms with an increase in leverage ratio tend to have less future investment. The results are after controlling for the effect of growth option on leverage ratio. These findings are consistent with a dynamic view of the pecking-order theory that an increase in leverage reduces firms' safe debt capacity and may lead to future underinvestment. This effect of debt capacity is not subsumed by the default risk, since the observed patterns are stronger for changes in long-term debt than short-term debt, and remain significant among financially healthy firms. Further, portfolios sorted by change in leverage ratio show no persistent pattern in future expected returns after the immediate price change. The combined results suggest that change in expected future cash flow, rather than the discount rate, is more likely the cause for the price change. Additional tests lend little support to the tradeoff or the market timing theories.
Keywords: Leverage, Debt Capacity, Stock Prices, Pecking Order
JEL Classification: G32
Suggested Citation: Suggested Citation
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