Financial Leverage, Corporate Investment and Stock Returns

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