Leverage change, debt capacity, and stock prices

• Main Authors: CAI, Jie, ZHANG, Zhe (Joe)
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2008
• Subjects: Leverage; Debt Capacity; Stock Prices; Pecking Order; Capital Structure; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/1429; https://ink.library.smu.edu.sg/context/lkcsb_research/article/2428/viewcontent/SSRN_id1107878.pdf
• Institution: Singapore Management University

We document a significantly negative effect of the change in a firm’s leverage ratio on its stock prices. This effect cannot be explained by popular asset pricing factors or firm characteristics. 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, even after controlling for growth option and target leverage. 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, thus reducing firm value. This effect of debt capacity is not subsumed by the default risk, since the return pattern also exists among financially healthy firms and portfolios sorted by change in leverage ratio show no obvious pattern in future expected returns after the immediate price change. Additional tests show that the price effect cannot be fully explained by the tradeoff or the market timing theories.