Financial Constraints, Debt Capacity, and the Cross Section of Stock Returns

43 Pages Posted: 4 Mar 2005

See all articles by Jaehoon Hahn

Jaehoon Hahn

University of Washington - Michael G. Foster School of Business

Hangyong Lee

KDI School of Public Policy and Management

Date Written: May 2005

Abstract

Theories of capital market imperfections have strong cross-sectional implications not only for corporate investment, but also for asset prices. Motivated by these theories, we develop a hypothesis about a differential effect of debt capacity on stock returns across financially constrained and unconstrained firms, based on a model of corporate investment under collateral constraints. The findings strongly support the hypothesis. Debt capacity is positively associated with stock returns in the cross section of financially constrained firms, after controlling for theoretical and empirical risk proxies such as beta, size, book-to-market, and momentum. The positive marginal impact of debt capacity is also economically significant. In contrast, debt capacity has no systematic relation with the cross section of financially unconstrained firms' stock returns. The results are robust to the way in which firms are classified into constrained and unconstrained groups and to the way in which debt capacity is measured. The findings suggest that cross-sectional differences in corporate investment behavior arising from financial constraints, predicted by theories of imperfect capital markets and supported by empirical evidence, are reflected in the stock returns of manufacturing firms.

Keywords: Debt capacity, capital market imperfection, financial constraint, cross-sectional stock returns

JEL Classification: G12

Suggested Citation

Hahn, Jaehoon and Lee, Hangyong, Financial Constraints, Debt Capacity, and the Cross Section of Stock Returns (May 2005). Available at SSRN: https://ssrn.com/abstract=676109 or http://dx.doi.org/10.2139/ssrn.676109

Jaehoon Hahn (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

Hangyong Lee

KDI School of Public Policy and Management ( email )

263 Namsejong-ro
Sejong-si 30149
Korea, Republic of (South Korea)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
728
Abstract Views
2,846
rank
38,317
PlumX Metrics