Financial leverage, corporate investment, and stock returns

This article rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model analytically shows that tax deductibility of interest payments increases effective investment irreversibility and that investment irreversibility weakens the relation between book-to-market values and returns. This provides a clear and novel mechanism showing how financial leverage affects stock returns beyond the standard Modigliani-Miller paradigm. The article argues that market leverage, rather than operating leverage or investment irreversibility, explains a major portion of the value premium. Empirical evidence supports this argument. (JEL G12, G31, G32) Firms with a high ratio of book value of equity to market value of equity (value firms) earn higher expected stock returns than do firms that have a low book-to-market equity ratio (growth firms). However, as Grinblatt and Titman (2001) point out, conventional wisdom tells us that growth options should be riskier than assets-in-place.1 Therefore, as Zhang (2005) stresses, growt