Levered Returns

45 Pages Posted: 2 Mar 2007

See all articles by Joao F. Gomes

Joao F. Gomes

The Wharton School

Lukas Schmid

University of Southern California - Marshall School of Business

Date Written: February 2007

Abstract

In this paper we investigate the theoretical relation between financial leverage and stock returns. Standard finance textbooks propose a straightforward link between capital structure and expected returns. Recent empirical work has highlighted evidence inconsistent with this view: Namely returns are negatively related to various measures of leverage. This paper provides an explanation of these regularities in term of firms' joint investment and financing decisions. In the presence of financial market imperfections leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer (risky) growth opportunities. We first formalize this intuition in a simple real options model and then study a more general quantitative model incorporating the same economic mechanisms. The quantitative version of our model can successfully replicate both recent empirical work as well as the more classic evidence in Bhandari (1988) and Fama and French (1992) about the effects of leverage on returns and the results in Welch (2004) about the impact of returns on leverage ratios.

Keywords: Cross-section of Returns, Growth Options, Financing, Leverage, Capital Structure

JEL Classification: G12, G31, G32

Suggested Citation

Gomes, João F. and Schmid, Lukas, Levered Returns (February 2007). Available at SSRN: https://ssrn.com/abstract=966076 or http://dx.doi.org/10.2139/ssrn.966076

João F. Gomes

The Wharton School ( email )

2329 SH-DH
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-3666 (Phone)
215-898-6200 (Fax)

HOME PAGE: http://fnce.wharton.upenn.edu/profile/gomesj/

Lukas Schmid (Contact Author)

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 431
Los Angeles, CA California 90089-1424
United States

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