Leverage, Excess Leverage and Future Returns
Posted: 28 May 2008 Last revised: 17 Jan 2013
Date Written: March 7, 2011
We examine the cross-sectional relation between leverage and future returns while considering the dynamic nature of capital structure and potentially delayed market reactions. Prior studies find a negative relation between leverage and future returns that contradicts standard finance theory. We decompose leverage into optimal and excess components and find that excess leverage tends to drive this negative relation. We also find that excess leverage predicts firm fundamentals, and that the negative relation between excess leverage and future returns may be explained by investors’ failure to react promptly to information contained in excess leverage about future financial distress and asset growth.
Keywords: leverage, excess leverage, stock returns, capital structure, market efficiency
JEL Classification: G12, G14, G32
Suggested Citation: Suggested Citation