Endogenous Leverage and Expected Stock Returns

Abstract

In a recent paper, George and Hwang (2009) assert that endogenous debt choice in a cross-section of diverse firms can imply a negative relation between leverage or distress risk and expected stock returns.

This note clarifies conditions, in the context of their model, under which this is so. We correct the contention that variation in bankruptcy costs is sufficient. Variation in firm risk parameters can lead to the desired relation, but may not when also controlling for variation in book-to-market ratios. A simple parameterization of cross-sectional heterogeneity in risk and profitability implies a negative association of expected return with leverage and distress risk and a positive association with book-to-market.

Keywords: expected stock returns, optimal capital structure

JEL Classification: G12