Leverage Change, Debt Capacity, and Stock Prices

42 Pages Posted: 7 Mar 2008

See all articles by Zhe Zhang

Zhe Zhang

Singapore Management University - Lee Kong Chian School of Business

Jie Cai

Drexel University

Multiple version iconThere are 2 versions of this paper

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

Zhang, Zhe and Cai, Jie, Leverage Change, Debt Capacity, and Stock Prices (March 3, 2008). Available at SSRN: https://ssrn.com/abstract=1101897 or http://dx.doi.org/10.2139/ssrn.1101897

Zhe Zhang

Singapore Management University - Lee Kong Chian School of Business ( email )

Lee Kong Chian School of Business
50 Stamford Road
Singapore, 178899
Singapore

Jie Cai (Contact Author)

Drexel University ( email )

LeBow College of Business
Philadelphia, PA 19104
United States
215-895-1755 (Phone)
215-895-2955 (Fax)

HOME PAGE: http://faculty.lebow.drexel.edu/CaiJ/

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