How Do Investors Perceive Optimal Capital Structure? Evidence From Industry-Specific Risk Factors

50 Pages Posted: 9 Jun 2022

See all articles by Nima Vafai

Nima Vafai

University of Texas of the Permian Basin

Date Written: May 31, 2022

Abstract

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.

Suggested Citation

Vafai, Nima, How Do Investors Perceive Optimal Capital Structure? Evidence From Industry-Specific Risk Factors (May 31, 2022). Available at SSRN: https://ssrn.com/abstract=4124495 or http://dx.doi.org/10.2139/ssrn.4124495

Nima Vafai (Contact Author)

University of Texas of the Permian Basin ( email )

4901 East University
Odessa, TX 79762
United States

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