Required Return on Equity when Capital Structure is Dynamic
Dai, Na and Piccotti, Louis R. (2018). Expected returns and capital structure adjustment, Financial Management, Forthcoming.
54 Pages Posted: 2 Jan 2016 Last revised: 19 Apr 2019
Date Written: November 21, 2018
We explore the firm’s required return on equity when it has a target debt ratio (TDR). We show that a firm’s expected return is increasing in the product of the distance between its debt ratio (DR) from its TDR (E[TDR-DR]), its speed of adjustment, and the spread of its tax benefits of debt over its bankruptcy costs of debt. Our empirical tests validate that high distance firms’ returns outperform those of low distance firms.
Keywords: Capital structure adjustment, empirical asset pricing, market efficiency
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