Financial Leverage, Corporate Investment and Stock Returns

76 Pages Posted: 23 Nov 2010

See all articles by Ali K. Ozdagli

Ali K. Ozdagli

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: November 16, 2010

Abstract

This paper rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model shows analytically that tax-deductibility of interest payments increases effective investment irreversibility and that investment irreversibility weakens the relationship between book-to-market values and returns. This provides a clear and novel mechanism showing how financial leverage affects stock returns beyond the standard Modigliani-Miller paradigm. The paper argues that operating leverage or investment irreversibility alone cannot generate the cross-sectional stock return patterns, and that market leverage is the main source of the value premium.

Keywords: value premium, investment irreversibility, capital structure

JEL Classification: G12, G31, G32

Suggested Citation

Ozdagli, Ali K., Financial Leverage, Corporate Investment and Stock Returns (November 16, 2010). Available at SSRN: https://ssrn.com/abstract=1713434 or http://dx.doi.org/10.2139/ssrn.1713434

Ali K. Ozdagli (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

HOME PAGE: http://sites.google.com/site/ozdagli/

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