Title

Leverage Change, Debt Capacity, and Stock Prices

Publication Type

Conference Paper

Publication Date

2008

Abstract

Using a sample of all available U.S. firms during 1975-2002, we document a significant, negative effect of quarterly change in a firm's leverage ratio on its stock returns This effect cannot be explained by the Fama-French three- or four-factor models and is robust after controlling for a number of firm characteristics such as ROE, book-to-market, firm size, past returns and past leverage ratio. Using several measures for debt capacity, we find that the negative effect is stronger for firms with limited debt capacity. Moreover, firms with an increase in leverage ratio tend to have less future investment, controlling for the potential negative effect of growth option on leverage ratio. These findings are consistent with a dynamic view of the pecking-order theory that an increase in leverage reduces firms' safe debt capacity and may lead to future underinvestment. This effect of debt capacity is not subsumed by the default risk. We find that the observed patterns are stronger for changes in the long-term debt than that in the short-term debt and remain significant among financially healthy firms. Further, portfolios sorted by change in leverage ratio show no persistent pattern in future expected returns in the year after the immediate price change. Additional analysis of the return pattern reveals results that are inconsistent with the trade-off or the market timing theories. We find that deviation from the target leverage ratio has no impact the stock returns. The combined results suggest that change in expected future cash flow due to the change in debt capacity, rather than the change in discount rate, more likely lead to the stock price change.

Keywords

Leverage, Debt Capacity, Stock Prices, Pecking Order

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Eastern Finance Association Annual Meeting, 9-12 April 2008

City or Country

St. Pete Beach, FL, USA

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