How Do Investors Perceive Optimal Capital Structure? Evidence From Industry-Specific Risk Factors
50 Pages Posted: 9 Jun 2022
Date Written: May 31, 2022
In this study, I examine the association between deviations from the optimal capital structure and firm-level stock returns and construct improved measures of industry-specific optimal capital structure. I then build an industry-specific risk factor based on this deviation. I compare the performance of multiple measures of optimal capital structure in revealing investors’ expectations and find that a positive (negative) deviation from the optimal capital structure is positively (negatively) associated with a stock’s excess return. I attribute this association to the increase in investors’ perceived risk. I find that our improved measure of optimal capital structure performs better than alternative measures in capturing the movement of firms towards target leverage. Using the Fama and French (1993-2015) methodology of mimicking portfolios, I model deviations from the optimal capital structure as a risk factor. I find that this factor is significantly associated with the cross-section of stock returns and that a risk mimicking portfolio can explain the risk loading on the cross-sectional excess return that is not explained by other known risk factors. Furthermore, I use the Text Network Industry Classification (TNIC) developed by Hoberg and Phillips (2010, 2016) to show that our results are robust to the method used for industry classification.
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