Asset Pricing Implications of Non-Convex Adjustment Costs of Investment

Abstract

This paper links the firm's book-to-market ratio and its loadings on common risk factors in asset returns, thereby providing a rationale for the observed value premium. If real investment is largely irreversible, the book value of a distressed firm is high relative to its market value. It has idle physical capital. The firm's extra installed capital capacity enables it to expand production easily in response to positive aggregate shocks. Thus, returns to equity holders of a high book-to-market firm are sensitive to aggregate conditions. Simulations indicate that the model goes a long way toward accounting for the observed value premium.

Keywords: Value Premium, Adjustment Costs, Irreversible Investment, Conditional Factor Loadings

JEL Classification: G12, D81, E22, D92