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Returns

Ali K. Ozdagli

November 16, 2010

Abstract

This paper 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

rm nancing and investment. The model shows analytically that tax-deductibility of inter-

est payments increases effective investment irreversibility and that investment irreversibility

weakens the relationship between book-to-market values and returns. This provides a clear

and novel mechanism showing how nancial leverage affects stock returns beyond the stan-

dard Modigliani-Miller paradigm. The paper argues that operating leverage or investment

irreversibility alone cannot generate the cross-sectional stock return patterns, and that market

leverage is the main source of the value premium.

Federal Reserve Bank of Boston, Ali.Ozdagli@bos.frb.org. This paper is a modied and improved version of my

Ph.D. thesis with the same title. I am grateful to Fernando Alvarez, Lars Hansen, Anil Kashyap, and Robert Lucas

for their support. I also thank Federico Diez, Francois Gourio, Satadru Hore, Tim Johnson, Sergey Koulayev, Oz

Shy, Christina Wang, and the seminar participants at the Federal Reserve Bank of Chicago, Federal Reserve Bank of

Boston, Boston University, AEA 2010 Atlanta meetings and The University of Chicago, in particular, Gene Fama and

Jarda Borovicka, for helpful comments. Sarojini Rao provided excellent research assistance. The usual disclaimer

applies.

1

Firms with a high ratio of book value of equity to market value of equity (value rms) earn higher

expected stock returns than rms that have a low book-to-market equity ratio (growth rms). How-

ever, 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, growth rms, which

derive their value from growth options, should have higher expected stock returns than value rms,

which derive their value from assets-in-place.

In addition, Fama and French (1992) show that portfolios of stocks with different book-to-

market ratios have similar riskiness as measured by the standard Capital Asset Pricing Model

(CAPM) of Sharpe (1964), Lintner (1965), and Black (1972). This phenomenon, known as the

“value premium puzzle,” helped the Fama and French model replace the CAPM as the benchmark

in the asset pricing literature.

This paper aims to explain the differences between the stock returns of value rms and growth

rms. For this purpose, I extend the investment irreversibility model of Abel and Eberly (1996)

by incorporating investors' risk preferences, risk-free debt contracts, and debt adjustment costs.

With this framework, I show that market leverage, dened as debt-to-assets ratio using market

values, can explain the major share of the value premium, while investment irreversibility without

leverage generates a growth premium rather than a value premium. This nding is different from

the recent literature that emphasizes investment irreversibility as the reason for the value premium,

such as Zhang (2005) and Cooper (2006). However, investment irreversibility is still an important

1

From p. 392 of Grinblatt and Titman (2001): "Consider Wal-Mart, for example. The value of this rm's assets

can be regarded as the value of the existing Wal-Mart outlets in addition to the value of any outlets that Wal-Mart may

open in the future. The option to open new stores is known as a growth option. Because growth options tend to be

most valuable in good times and have implicit leverage they contain a great deal of systematic risk."

2

ingredient that improves the model's t with the data, by generating a wide range of book-to-market

values.

The nancing decisions in this model are similar, but not identical, to those of Fischer, Heinkel,

and Zechner (1989) and Gomes and Schmid (2010). These papers assume that existing debt is

retired at the time of the new issues and add capital restructuring costs to the standard tradeoff

theory of capital structure whereby a rm chooses its nancing policy by balancing the costs of

bankruptcy against the benets of debt, such as tax shields due to interest payments. My paper

also assumes that rms benet from the tax shield of debt as in the tradeoff theory and that they

face additional costs at the time of debt restructuring.

However, in this paper, debt has two properties distinct from its properties in previous papers:

it is risk-free and endogenously limited by the lenders to a certain fraction of capital. Since interest

payments are tax deductible, the rm prefers debt nancing to equity nancing and would rather

have an innite amount of debt. But this would lead to negative equity value in some states where

the rm would rather go bankrupt than pay its debt. Therefore, for debt to remain risk-free, lenders

will limit the amount of debt. They can accomplish this by accepting the resale value of capital as

collateral and ensuring that this value is not lower than the amount of debt, so that they can recover

their money in case of bankruptcy.

2

Alternatively, lenders may limit the amount of debt in order to

ensure that the market value of equity is always non-negative so that bankruptcy is suboptimal for

the rm. I show that the market value of equity is strictly positive when the debt capacity equals

the resale value of capital. Therefore, the collateralized debt agreement is more restrictive than

2

This is a common assumption in the papers that model risk-free debt. A recent example is Livdan, Sapriza, and

Zhang (2009).

3

the debt agreement that induces a non-negative market value of equity and the suboptimality of

bankruptcy. So, the latter policy provides the rm with a higher debt capacity and the rm prefers

this latter debt policy, while the lenders are indifferent.

One important property of the model is that the rm's book leverage, that is, the fraction of total

capital supplied by lenders, is not state-dependent. The book leverage is determined in a manner

that ensures that the rmvalue is non-negative even in the worst-case scenario, to avoid bankruptcy.

I show that this worst-case scenario is independent of the state variables, and hence a revision of

the debt agreement at a later date would lead to the same level of leverage. Thus, it is not optimal

for a rm to change its book leverage once it is set. As a result, the book leverage remains the

same across rms with different ratios of book-to-market equity, whereas market leverage differs

signicantly. Figure 1 plots averages of book and market leverage within different book-to-market

portfolios and provides support for this argument. Moreover, because the level of debt is constant

in the inaction region (when the rm does not invest), the rm's market debt-to-equity ratio varies

closely with uctuations in its own stock price. This implication of the model is in line with the

results of Welch (2004), who nds that U.S. corporations do little to counteract the inuence of

stock price changes on their capital structures.

My analysis shows that investment irreversibility without leverage causes a growth premium

rather than a value premium in the model. The rm's investment opportunity is a call option,

because the rm has the right, but not the obligation, to buy a unit of capital at a predetermined

price. As we know from the nancial options literature, when the price of the underlying security

rises and falls, the price of the call option rises and falls at a greater rate. This suggests that the value

4

Figure 1: Market and book leverage across book-to-market (BE/ME) portfolios. This gure

presents book leverage and market leverage across different book-to-market value portfolios. The

numbers on the horizontal axis give the average book-to-market equity value in each portfolio. The

numbers on the vertical axis give the average market and book leverage in each portfolio. At the

beginning of each year portfolios are formed on the basis of ranked values of BE/ME, where each

portfolio covers a decile. Book equity (BE) is the book value of common equity (item 60) plus

deferred taxes and investment tax credit (item 35) from annual COMPUSTAT les. Market value

of equity (ME) is price of each share times the number of shares outstanding from CRSP database.

Book leverage is total assets (COMPUSTAT item 6) minus book equity divided by total assets.

Market leverage is total assets minus book equity divided by total assets minus book equity plus

market equity. The accounting data for all scal year-ends in calendar year t 1 is matched with

market equity at the end of December of year t 1, as in Fama and French (1992). Source: The

Center for Research in Security Prices, CRSP-COMPUSTAT merged database, from 1963 to 2008

for t.

5

of a growth option, that is, the call option to invest, should be more responsive to economic shocks

than the assets-in-place. Therefore, growth options increase the riskiness of the rm.

3

Similarly,

the disinvestment opportunity is a put option, because the rm has the right, but not the obligation,

to sell a unit of capital at a predetermined price. The value of this put option is negatively related to

the value of the underlying asset, because the gain from exercising it is higher for less productive

rms. Therefore, the disinvestment option provides the value rms that have low productivity with

insurance against downside risk and hence reduces their riskiness. This proposition is different

from the results of recent literature, for example, Zhang (2005) and Cooper (2006), which presents

investment irreversibility as the source of the value premium.

4

In my model, nancial leverage affects stock returns directly, through its effect on equity risk as

in Modigliani and Miller (1958), and indirectly, through its effect on business risk, by inuencing

investment decisions. I nd that these two channels have opposing effects on the relationship

between book-to-market ratios and stock returns. However, the Modigliani-Miller effect strongly

dominates the investment channel and explains the major share of the value premium.

The Modigliani-Miller (1958) effect of debt comes from the fact that the book-to-market ratio

and market leverage are closely related when book leverage is constant, as we observe within the

context of this model and in Figure 1. In particular, if we let 11. `1, 11, and `1 be the book

3

This pattern is in line with Bernardo, Chowdhry, and Goyal (2007) who show that the beta of growth opportunities

is greater than the beta of assets-in-place for the unlevered rm.

4

Hall (2004) estimates the adjustment cost parameter for capital in a quadratic adjustment cost model without

debt and nds that adjustment costs are relatively small and are not an important part of the explanation of the large

movements in company values.

6

value of equity, market value of equity, book leverage, and market leverage, respectively, we have

11

`1

=

`1

1 `1

1 11

11

. (1)

Because book leverage is constant across value and growth rms, this equation implies that, in the

model, market leverage is the main source of variation in book-to-market values and that value

rms have higher market leverage than growth rms. Therefore, they have greater equity risk

according to the Modigliani and Miller theorem.

Financial leverage also affects investment and hence the business risk in the model, because

it inuences the effective degree of investment irreversibility faced by the owners of the rm.

When investment can be nanced with leverage, the effective price of capital is reduced by the tax

savings associated with debt nancing at the time of investment. On the other hand, at the time

of disinvestment, the rm has to pay back its debt, in line with the debt agreement, and therefore

has to give up the tax savings associated with the debt nancing of that particular investment.

Because the purchase price is greater than the resale price and both should be adjusted by the same

value of tax savings, their ratio increases as a result of debt nancing. This increases the effective

irreversibility perceived by the owners of the rm. Since irreversibility reduces the value premium,

so, too, does the investment channel of leverage.

The risk-free debt assumption is not critical, at least qualitatively, for the main results of the

paper; in particular it is not critical to understanding how market leverage affects stock returns

through the Modigliani and Miller channel and the investment channel, as the intuition for these

7

channels does not depend on the risk-free debt assumption. The Modigliani and Miller channel

simply states that equity of rms with higher market leverage is riskier and the investment chan-

nel intuition is based on the tax advantage of debt. The Modigliani and Miller paradigm and tax

deductibility of interest payments would still be present in a model with risky debt. The relation-

ship between market leverage and book-to-market value would also be unaffected as long as book

leverage does not vary signicantly across rms in different portfolios but rather obeys the data

as shown in Figure 1. Nevertheless, the capital structure choice in my model has two advantages.

First, it provides consistency between theoretical and empirical analysis. Because we do not ob-

serve the market value of debt, many studies that relate risky debt to returns use the book value

of debt as a proxy for the market value of debt. However, this contradicts the assumption of risky

debt because the value of risky debt is not equal to the book value of debt. Second, in a tradeoff

model with risky debt, more productive rms, which also have lower book-to-market values, tend

to choose higher debt relative to their total capital because they have lower bankruptcy probabil-

ity for a given debt level. This implies that book leverage would not be constant across different

book-to-market portfolios, in contrast with the data in Figure 1.

This paper is closely related to the growing literature that links corporate decisions to asset

returns. Like Zhang (2005) and Cooper (2006), Carlson, Fisher, and Giammarino (2004) have a

model with investment irreversibility but link the value premium to operating leverage rather than

investment irreversibility. Gomes and Schmid (2010) link leverage and growth options to asset

returns when issuing equity is costly and Livdan, Sapriza, and Zhang (2009) look at the effect of

exogenous risk-free debt capacity on stock returns.

8

My paper contributes to this literature in many ways. First, unlike Livdan, Sapriza, and Zhang

(2009), the risk-free debt capacity of the rm is endogenously determined. Second, the closed-

form solution of the model identies explicitly how investment irreversibility, nancial leverage,

and their interaction affect the cross-section of stock returns. Gomes and Schmid (2010) emphasize

that nancial leverage affects growth options, which in turn affect stock returns, creating a channel

beyond the Modigliani and Miller paradigm. However, they do not focus on how leverage changes

investment decisions and how this channel affects the relationship between book-to-market val-

ues and stock returns. My paper provides a clear and novel mechanism showing that nancial

leverage increases effective investment irreversibility and that investment irreversibility weakens

the relationship between stock returns and book-to-market values in a model that incorporates not

only a growth option but also a disinvestment option. Third, the paper provides a novel calibration

exercise that ts the model to the distribution of book-to-market values via maximum likelihood

and shows that the model captures the empirical patterns of book leverage, market leverage, book-

to-market values, and stock returns across different book-to-market portfolios reasonably well.

5

Fourth, the paper provides both theoretical and empirical analysis consistent with the claim that

market leverage can explain the major portion of the value premium.

Finally, the mechanism that relates nancial leverage to stock returns through the investment

channel in the model suggests two new testable implications: Because nancial leverage increases

effective investment irreversibility through the interest tax-shield, rms with a greater interest tax-

5

To the best of my knowledge, no other paper in the literature makes an effort to match the distribution of book-

to-market values and leverage, although this distribution is important in generating the cross-sectional distribution of

returns. The implications of omitting this fact are crucial and are discussed in the Calibration section.

9

shield invest as if they faced greater investment irreversibility.

6

Moreover, the relationship between

investment irreversibility and stock returns in the model suggests that industries with a higher

degree of investment irreversibility, after taking leverage and the interest tax shield into account,

should have a weaker relationship between book-to-market values and stock returns.

The next section introduces data and variables, and presents supporting evidence that favors

market leverage over other channels in explaining the value premium. The second section presents

the problem of the rm in a continuous time setting. The third section then discusses the optimal

investment policy and the market value of equity. The fourth section presents optimal nancing

policy and its relationship with investment. The fth section links stock returns with investment

irreversibility and nancial leverage. The sixth section presents the calibration of the model and

the comparison of simulation results with the data. The seventh section provides a discussion of

the results and reconciles evidence from earlier literature with the paper's claims. The last section

concludes.

I. Data and Supporting Evidence

The choice of data closely follows Fama and French (1992). The only exception is that I include

all rms in the NYSE, AMEX and NASDAQ in the monthly CRSP database, whereas Fama and

French (1992) include only nonnancial rms. Many recent papers, such as Carlson, Fisher, and

Giammarino (2004) and Zhang (2005), use the data series published on Kenneth French's website

and, unlike the data in Fama and French (1992), these data series include all rms. Therefore, in-

6

The effect of irreversibility on investment is discussed by Abel and Eberly (1994, 1996) in detail.

10

cluding all rms makes my results comparable to previous literature, although excluding nancial

rms does not change any result signicantly. As in Fama and French (1992), this dataset is then

merged with the annual balance sheet les from Compustat database. The dataset covers the period

1962 to 2008.

The creation of variables also closely follows Fama and French (1992). Accordingly, I match

the accounting data for all scal year-ends in calendar year t 1 (1962-2007) with the returns for

the period starting July of year t to June of year t + 1. Moreover, I use a rm's market equity at

the end of December of year t 1 to compute its book-to-market and market leverage. Market

value of equity is dened as the price of each share times the number of outstanding shares from

the CRSP database. Book value of equity is dened as the sum of book value of common equity

(COMPUSTAT code CEQ/ item number 60) plus deferred taxes and and investment tax credit

(COMPUSTAT code TXDITC/ item number 35) from Compustat database.

7

Therefore, the book

value of debt is equal to total assets (COMPUSTAT code AT/ item number 6) minus book value

of equity, and book leverage is equal to book value of debt divided by total assets. Finally, as in

Gomes and Schmid (2010), market leverage is equal to book value of debt divided by the sum of

book value of debt and equity. The dates of the numerator and denominator in the book-to-market

ratio and market leverage are not aligned, and the implications of this are discussed in Fama and

French (1992).

In order to support my claim that market leverage is the main reason for the value premium, I

unlever equity returns using the Modigliani-Miller relationship :

¹

= `1 :

1

+ (1 `1) :

1

7

Fama and French (1992) add only deferred taxes, whereas Fama and French (1993) add both deferred taxes and

investment tax credit, a practice I follow.

11

where :

¹

is the return on total assets (i.e., unlevered returns), `1 is the market leverage, :

1

is

the return on debt, and :

1

is the return on equity. For return on debt I use monthly returns on the

T-Bill, taken from CRSP. The purpose of this exercise is to see what is left over from the value

premium after accounting for the direct effect of nancial leverage. The results are provided in

Figure 2. I have also used an alternative measure of return on debt, given by the ratio of the interest

expense to total debt. The results are similar.

Figure 2 shows that the major chunk of the value premium vanishes after this unlevering ex-

ercise, which is in line with the paper's claim that market leverage is the main reason behind the

value premium. In particular, note that the value premium between the top and bottom deciles re-

duces from 16% to 4%. The result is even more drastic if we compare the value premium between

the second decile and the top decile; the value premium between these deciles reduces from 14%

to 2% after unlevering. Hecht (2001) performs a similar analysis using market values for bond

data, and a new working paper by Choi (2010, Table VI, panel A) uses both bond and loan data

to unlever returns. Their analysis also shows that unlevered returns vary much less than levered

returns across book-to-market portfolios.

Of course, both my approach and the approaches of Choi and Hecht have their shortcomings:

My unlevering exercise calculates market leverage by replacing the market value of debt with the

book value of debt and uses the risk-free rate for the return on debt. Hecht's and Choi's approaches

use market values, but bonds and bank loans are traded infrequently in the secondary markets and

they do not consider accounts payable as a source of debt. In addition, their sample includes rms

for which they have bond and loan data covering only half of the Compustat rms and a shorter

12

Figure 2: Stock returns and unlevered returns across book-to-market portfolios. This gure

presents actual and unlevered stock returns across different book-to-market value portfolios. The

numbers on the vertical axis give the time series average of equally weighted cross-sectional

means of returns for each portfolio in annualized percentages. At the beginning of each year

portfolios are formed on the basis of ranked book-to-market values, where each portfolio covers

a decile. Book-to-market value, market leverage, and book leverage are dened in the caption

of Figure 1. The accounting data for all scal year-ends in calendar year t 1 is matched with

market equity at the end of December of year t 1 and the returns for the period starting July

of year t to June of year t + 1, as in Fama and French (1992). The stock returns come from the

monthly CRSP series and the unlevered return for each month is calculated using the weighted

average of stock returns and monthly T-Bill returns from CRSP, where the weight of the T-Bill

return is market leverage. Source: The Center for Research in Security Prices (CRSP), CRSP-

COMPUSTAT merged database, from July 1963 to June 2008.

13

time period. Nevertheless, it is striking that all these approaches yield to similar conclusions.

This exercise also provides evidence that favors market leverage channel over the operating

leverage channel in explaining the value premium. Operating leverage is the leverage of the all-

equity nanced (unlevered) rm, as illustrated in Carlson, Fisher, and Giammarino (2004). There-

fore, operating leverage cannot claim to capture more than a small portion of the value premium

left over from this unlevering exercise.

II. The Model

My model extends the investment irreversibility model of Abel and Eberly (1996) with corporate

taxes, debt, and a stochastic discount factor to capture investors' risk preference. While debt ca-

pacity and investment and nancing decisions are endogenous, investors' preferences are captured

by an exogenous discount factor, as in Zhang (2005), Cooper (2006), and Carlson, Fisher, and

Giammarino (2004), among others.

The rms choose their investment and nancing policy in order to maximize the market value

of equity. Investment is subject to partial irreversibility, that is, the purchase price of one unit

of capital is 1 and the resale price is j < 1. Each rm produces output at time t using capital,

1

t

, and takes the level of productivity, A

t

, and the stochastic discount factor of investors, o

t

, as

14

exogenously given. Both A

t

and o

t

follow geometric Brownian motions

dA

t

A

t

= j

A

dt + o

¹

dn

¹

+ o

i

dn

i

= j

A

dt + odn (2)

do

t

o

t

= :dt o

S

dn

¹

. (3)

where 1

t

[do

t

,o

t

] = :dt is the interest rate and o

S

is the price of risk. The Brownian increments

dn

¹

and dn

i

represent systematic and idiosyncratic shocks and are independent of each other.

They can be aggregated using o =

_

o

2

i

+ o

2

¹

and dn = (o

i

,o) dn

i

+ (o

¹

,o) dn

¹

. Moreover, if

we let l

t

and 1

t

denote total capital purchases and total capital sales, respectively, up to time t, we

can write the net change in the stock of capital as

d1

t

= dl

t

d1

t

. (4)

where dl

t

0 and d1

t

0.

The net income of the rm is given by the operating cash ows net of the cost of maintenance

and cash ows to debtholders plus tax shields from maintenance and interest payments:

:

t

: (1

t

. A

t

. /

t

) = (1 t)

_

/

1 ¸

A

¸

t

1

1¸

t

o1

t

:/

t

1

t

_

. (5)

where t is the tax on corporate income, / 0 is the productivity multiplier, and 0 < ¸ < 1

is the returns-to-scale parameter of the production function. On the cash outow side, o is the

maintenance cost per unit of capital, : is the risk-free rate on debt, and /

t

is the the ratio of the

15

book value of debt to the book value of assets, or book leverage. In accordance with tax laws,

the net income incorporates the tax deductiblity of interest payments. Except for taxes, debt, the

investors' stochastic discount factor, and maintenance costs, all the assumptions are the same as in

Abel and Eberly (1996). The assumptions regarding maintenance cost and the stochastic discount

factor are similar to those in Carlson, Giammmarino, and Fisher (2004). The tax structure is similar

to that in Miao (2005), among others. I also assume, for the sake of simplicity, that the accounting

salvage value of the capital is the same as the actual salvage value, so that the rm does not pay

any tax on the resale price of capital, as in Carlson, Giammmarino, and Fisher (2004), Gomes and

Schmid (2010), and Miao (2005), among others.

I model nancial leverage as risk-free debt extended through a credit line, where the debthold-

ers agree to nance a certain fraction of operating capital. Intuitively, the lenders can keep the debt

risk-free by a collateralized debt agreement and can limit the amount of debt by the resale price of

capital so that j /. Alternatively, they can set a limit on debt that guarantees that the rm always

has non-negative market equity and hence honors its debt rather than going bankrupt. The rm has

the option to renegotiate this fraction later, but debt restructuring requires that the existing debt be

retired altogether and that new debt be issued at a cost proportional to the amount of new debt, c,

as in Fisher, Heinkel, and Zechner (1989).

As a result of this debt agreement, the rm will invest when the marginal value of capital to

equity holders is 1 /, as this is the fraction of new investment that should be nanced with

equity. Moreover, the rm will disinvest when the marginal value of capital is j /, because the

rm gets j for each unit of capital sold but has to give back / to debtholders in order to keep the

16

book leverage constant, in accord with the debt agreement. In the following analysis, A

l

(1. /)

and 1

l

(A. /) denote the investment boundary along which the marginal value of capital is 1 /,

while A

1

(1. /) and 1

1

(A. /) denote the disinvestment boundary along which the marginal value

of capital is j /.

8

These two boundaries enclose the inaction region, where the marginal value

of capital is between 1 / and j / and net investment is zero. This investment policy will be

discussed in more detail in the next section.

Because the lenders are indifferent between a collateralized debt agreement and the no-bankruptcy

debt agreement, it is up to the rm which agreement to choose. The following proposition estab-

lishes that the rm will never go bankrupt under a collateralized debt agreement.

Proposition 1 The market value of equity is strictly positive if debt is limited by the resale price

of capital.

Proof. We have j / if debt is limited by the resale price of capital. The market value of

equity is bounded by (j /) 1 0, because this is what the shareholders will get after pay-

ing the lenders if they decide to dissolve the rm. Let J (A. 1. /) be the market value of equity

and 1

l

(A. /) be the investment boundary. Then J (A. 1. /) (j /) 1 must hold at the in-

vestment boundary, 1

l

(A. /), since otherwise the rm would dissolve immediately, leaving the

shareholders with capital (j /) 1 in return to their investment (1 /) 1 (j /) 1. There-

8

Because the investment boundary is a surface in the (X; K; b) space, we can express it either as K

U

(X; b) or as

X

U

(K; b). The same holds for the disinvestment boundary.

17

fore, J (A. 1

l

(A. /) . /) 0. Finally, we can write the market value of equity as

J (A. 1. /) = J (A. 1

l

(A. /) . /) +

_

1

1

U

(A,b)

J

1

(A. /. /) d/. (6)

where 1 / J

1

(A. 1. /) j / 0, because the marginal value of capital is bounded

due to investment and disinvestment options. We also have 1 1

l

(A. /) for any given A and /,

because the rm will invest to prevent the value of capital from falling below1

l

(A. /). Therefore,

the integral on the right side of this equation should be positive. Since the sum of the two positive

terms is positive, we have J (A. 1. /) (j /) 1 0, and this completes our proof.

This proposition essentially tells us that even if the rm had the option to go bankrupt, it

would never exercise this option if debt were limited by the resale price of capital, because the

disinvestment boundary would be hit before bankruptcy became optimal. It follows immediately

that the debt agreement with a no-bankruptcy condition is less restrictive. In particular, it provides

a greater debt limit because the market value of equity is still non-negative if the lenders lend the

rm more than the resale value of its capital.

9

Since bankruptcy is suboptimal under both lending

policies, I omit bankruptcy in the rest of the paper.

9

The choice of the rm between risk-free debt policies does not affect the results of the paper qualitatively. How-

ever, the condition < b creates a greater degree of irreversibility by increasing the wedge between the investment

and disinvestment boundaries and hence improves the t of the model-implied book-to-market distribution to data.

18

The rm maximizes shareholder value by choosing its investment and nancing plans:

J (1

t

. A

t

. /

t

) = 1

t

max

fol

t+s

,o1

t+s

,ob

t+s

g

_

1

0

o

t+c

o

t

[ :

t+c

d: (1 /

t+c

)dl

t+c

+ (j /

t+c

) d1

t+c

]

+

1

c2fc:ob

t+s

6=0g

o

t+c

o

t

[d/

t+c

c(/

t+c

+ d/

t+c

)] 1

t+c

. (7)

where the term d/

t+c

is the change in book leverage after debt adjustment, and

_

1

0

dl

t+c

and

_

1

0

d1

t+c

are Stieltjes integrals. Note that the stochastic discount factor does not appear as a state

variable in the value function J, because o

t+c

,o

t

is log-normally distributed with parameters :t

and o

2

S

t and this distribution does not depend on any state variable. The rst term, the integral, in

equation (7) is the discounted value of after-tax prots net of cash inows and outows through

the purchase and resale of capital. The second term in equation (7) is the discounted value of debt

adjustment costs.

The debt limit imposed by the lenders adds an additional constraint to the problem. If debt is

limited by the resale value of capital, then this constraint is simply /

t+c

j. If, on the other hand,

debt is limited by the no-bankruptcy condition then we have

0 J (1

t+c

. A

t+c

. /

t+c

) for all 1

t+c

. A

t+c

. /

t+c

. (8)

Although the debt policy with the no-bankruptcy condition provides a greater debt capacity than

the collateralized debt policy, we still cannot rule out the latter until I show that debt nancing is

preferred to equity nancing. Proposition 3 in section IV serves this purpose.

19

Because of investment and debt adjustment costs, it is not optimal for the rm to adjust capital

and debt frequently. The Hamilton-Jacobi-Bellman equation (HJB) in the inaction region, where

the rm does not make any adjustments, is given by

:J (1. A. /) = : (1. A. /) + jAJ

A

(1. A. /) +

1

2

o

2

A

2

J

AA

(1. A. /) . (9)

where j = j

A

o

S

o

¹

is the risk-adjusted drift of the productivity process. This is practically the

same as substituting the stochastic discount factor with the risk-free rate and taking expectations

under the risk-neutral measure. When we divide both sides of this equation by the market value

of equity, J, this equation tells us that the required rate of return from buying the rm should

be equal to the dividend yield (the rst term) plus expected capital appreciation under the risk-

adjusted productivity process (the second and third terms). The solution of the partial differential

equation (9) requires that we specify some boundary conditions, the so-called value matching and

smooth pasting conditions. These conditions, presented in the appendix, guarantee the continuity

and optimality of the value function.

10

10

Dixit (1993) is a good introduction to the derivation of these conditions.

20

III. Optimal Investment Policy and the Valuation of Equity

Since equation (9) holds identically in 1, we can take the derivative of both sides with respect to

1 to get

:J

1

(1. A. /) = :

1

(1. A. /) + jAJ

1A

(1. A. /) +

1

2

o

2

A

2

J

1AA

(1. A. /) . (10)

Because all terms in the rm's problem are homogeneous of degree one in A and 1, the value

of the rm should also be homogeneous of degree one in A and 1. As a result, the marginal

value of capital should be homogeneous of degree zero in A and 1. Therefore, we can dene

the ratio of productivity to capital, ¸ A,1, and the marginal value of capital to shareholders,

¡ (¸. /) J

1

(1. A. /), to express the last equation as

:¡ (¸. /) =

/¸

¸

: + j¸¡

j

(¸. /) +

1

2

o

2

¸

2

¡

jj

(¸. /) . (11)

where

/ = (1 t) / and :(/) = (1 t) (o + :/) is the tax adjusted marginal cost of maintenance

and nancing. Then, the boundary conditions at the upper and lower investment bounds are given

by the following equations.

11

¡ (¸

l

(/) . /) = 1 / and ¡

j

(¸

l

(/) . /) = 0 (12)

¡ (¸

1

(/) . /) = j / and ¡

j

(¸

1

(/) . /) = 0. (13)

11

We can see that the additional smooth pasting conditions for b, that is, q

b

(y

L

(b) ; b) = q

b

(y

L

(b) ; b) = 1; are

automatically satised once we take the derivative of the value-matching equations with respect to b and apply the

smooth pasting conditions for y. Therefore, we omit these conditions for the rest of the analysis.

21

X

(productivity)

K (capital)

Slope = y

U

(b)

Slope = y

L

(b)

disinvestment

region

investment

region

inaction region

b q b − < < − 1 η

b q − =1

b q − =η

Figure 3: Projection of investment and inaction regions on the K-X plane. The line with slope

¸

l

(/) gives the investment boundary where the marginal value of capital, ¡, is equal to 1 /, the

net cash outow per unit purchase of capital, where / is book leverage. The line with slope ¸

1

(/)

gives the disinvestment boundary where the marginal value of capital, ¡, is equal to the net cash

inow per unit sale of capital, j /, where j is the resale value capital. These two boundaries

enclose the inaction region for investment, where the marginal value of capital is bounded by 1 /

and j /.

This reduces the original HJB equation to an ordinary differential equation; solving this involves

nding two constants of integration and the boundary values for ¸. Figure 3 displays the projection

of the investment and inaction regions implied by the boundary conditions on the (1. A) plane.

The appendix shows that solving these equations and integrating the marginal value of capital

leads to

J (1. A. /) =

HA

¸

1

1¸

+

1

1

(/) A

c

P

1

1c

P

+

1

.

(/) A

c

N

1

1c

N

:(/)

:

1. (14)

22

where c

1

1 ¸ 0 c

.

, and

1

1

(/) and

1

.

(/) are functions of book leverage that take

only positive values. The four terms are the value of assets in place (before costs), growth options,

disinvestment options, and the present value of maintenance and nancing costs. Note that book

leverage, /, is constant in the inaction region due to debt adjustment costs. Therefore, any effect

of debt adjustment on the market value of equity should be captured by constants of integration

1

1

(/) and

1

.

(/) . and hence equation (14) does not have a separate term for the debt adjustment

option.

IV. Financial Leverage and Investment

We now turn our attention to optimal nancing policy and its relationship with investment. The fol-

lowing proposition shows that the tax advantage of leverage makes the rm choose its investment

policy as if it faced greater irreversibility. Then I show that the optimal nancing policy for the

rm is to exhaust its debt capacity. Therefore, the rm prefers the no-bankruptcy condition because

it provides greater debt capacity. Finally, I show that the debt capacity under the no-bankruptcy

condition is independent of state variables.

Proposition 2 When interest payments are tax deductible, the gap between the investment bound-

ary and the disinvestment boundary as measured by G(/) ¸

l

(/) ,¸

1

(/) increases with book

leverage /.

Proof. See appendix

23

Intuitively, the gap between the investment and disinvestment boundaries increases as the ratio

of the purchase to the resale price increases, because it is this discrepancy between prices that cre-

ates investment irreversibility. Then, we should answer why the purchase price increases relative to

the resale price. When investment is nanced with leverage, the shareholders care not only about

the actual price of capital but also about the nancing costs. In the absence of tax deductibility of

interest payments, there would be no net gain from borrowing because the amount of investment

nanced through borrowing would be paid back to lenders through interest. When there is tax

deductibility, the rm still pays interest to lenders but it has to pay less tax to the government. At

the time of investment, the net purchase price of capital from the shareholders' perspective is the

actual price net of any tax savings due to debt nancing. At the time of disinvestment, the net

resale price of capital is the actual price minus the loss of tax deductions due to debt repayment.

Since the purchase and resale prices of capital decrease by the same amount of tax savings, their

ratio should increase. This increases the effective irreversibility perceived by the shareholders.

The next two propositions show that the optimal behavior for the rm is to use all of its debt

capacity at once if the cost of issuing debt is sufciently small so that the tax savings due to

interest payments dominate the cost of debt nancing and never to adjust its book leverage after

that. I assume that the cost of issuing debt is below this limit.

12

Proposition 3 Let G(/) ¸

l

(/) ,¸

1

(/) 1. Then, there is a critical level for the cost of issuing

12

The parameter estimates for the calibration of the model imply that c

**is 2.3 percent, which is above the level used
**

in the literature. For example, Fischer, Heinkel, and Zechner (1989) use 1 percent for the corresponding parameter in

their model.

24

debt, given by

c

= t

_

1

1

1 c

.

_

0 (15)

below which the rm strictly prefers debt to equity.

Proof. See appendix

Proposition 4 It is never optimal to readjust debt.

Proof. The appendix shows that J

b

(A. 1. /) + 1 0. Therefore, the smooth pasting conditions

required at debt restructuring are not satised.

The intuition for this proposition follows from the envelope theorem. Section A. of the appen-

dix shows that J

b

(A. 1. /) + 1 = 0 should hold at the debt adjustment boundary for debt adjust-

ment to be optimal and discusses how this condition can be interpreted as an envelope condition.

In particular, if the before-adjustment book leverage, /, changes by a small amount, d/, the amount

of debt the rm has to repay at the time of adjustment increases by (d/)1. If debt adjustment

were optimal, i.e., if debt adjustment were to maximize the market value of equity, J(A. 1. /),

then the shareholders should have been compensated by the same amount, which would imply that

J

b

(1. A. /)d/ + 1d/ = 0 or J

b

(1. A. /) + 1 = 0 at the debt adjustment boundary. Because

J

b

(1. A. /) + 1 0 for all (A. 1. /), this optimality condition is violated, i.e., debt adjustment

cannot be an optimal policy, for any choice of adjustment boundary.

The following proposition shows that the leverage limit set by the debtholders is the same for

all rms regardless of their productivity and capital levels.

Proposition 5 The debt limit implied by the no-bankruptcy condition is not state-dependent.

25

Proof. Using equation (14) we can write the no-bankruptcy condition J (1. A. /) 0 as

J (1. A. /) ,1 = J (1. ¸. /) 0, that is,

J (1. ¸. /) = H¸

¸

+ 1

1

(/) ¸

c

P

+ 1

.

(/) ¸

c

N

:

:

0. (16)

Moreover, J (1. ¸. /) should be increasing in ¸ because, given capital and leverage, more productive

rms should have higher market value, that is, J

A

(1. A. /) 0. Therefore, J (1. A. /) 0 for

all (A. 1. /) if and only if J (1. ¸

1

(/) . /) 0. As a result, the debt limit is given by the equation

J (1. ¸

1

(/) . /) = 0, whose solution is independent of state variables.

This proposition tells us that the book leverage in this model should not be state-dependent

because the debt limit is determined by the worst-case scenario, which is not state-dependent due

to the homogeneity of the rm's value. This result is important for two reasons: First, it strengthens

the result that it is not optimal to adjust debt once it is set, because it is costly to adjust and the new

limit would be the same as the old one. Second, because the debt limit as a fraction of total capital

is the same for all rms, book leverage is the same across rms with different book-to-market

ratios. Figure 1 shows that this implication of the model ts the data.

Propositions 4 and 5 also imply that the book leverage is constant over time. This simplies

the analysis of the model. However, we can easily generalize the model with time-varying book

leverage: Suppose that the resale value of capital, j, is changing over time. The debt limit can be

either set via / < j or via the no-bankruptcy condition, so that in each case it can be conditioned

on the resale value of capital. Then, since the homogeneity of the problem in A and 1 still holds,

26

the investment boundaries would be given by A,1 = ¸

l

(/. j) and A,1 = ¸

1

(/. j). Following

the proof of proposition 5, the no-bankruptcy debt limit would be given by J (1. ¸

1

(/. j) . /) = 0,

implying that the debt limit is a function only of the resale value, / (j). As a result, although book

leverage is time varying with j, it would still be constant across different book-to-market portfolios

without changing the other properties of the model.

V. Stock Returns

A. Investment Irreversibility and Stock Returns

In order to isolate the pure effect of investment irreversibility on stock returns, I focus on a rm

that does not have any operating costs and nancial leverage. In this case, the market value of

rm's equity is given by

J (1. A) = HA

¸

1

1¸

+ 1

1

A

c

P

1

1c

P

+ 1

.

A

c

N

1

1c

N

. (17)

where c

1

1 ¸ 0 c

.

and H,1

1

, and 1

.

are positive constants. These three terms

capture the market value of the assets-in-place, the growth options, and the disinvestment options,

which I denote J

¹1

. J

G

, and J

1

. respectively.

Using Ito calculus and some algebra, we can derive the (conditional) expected excess stock

27

return as

1

dt

1 (d1) : =

1

dt

1

_

:dt + dJ

J

_

: = o

S

o

¹

J

A

A

J

= o

S

o

¹

_

J

¹1

J

¸ +

J

G

J

c

1

+

J

1

J

c

.

_

= o

S

o

¹

(:

¹1

¸ + :

G

c

1

+ :

1

c

.

) . (18)

Therefore, the expected excess stock return is a value-weighted average of expected excess returns

that come from the three sources of value. Since the book-to-market ratio can be expressed as

(1 /) 1,J (1. A) = (1 /) ,J (1. ¸), the ratio of productivity to capital, ¸, is negatively related

to the book-to-market ratio. The appendix shows that the expected stock return increases in ¸

and hence decreases in book-to-market values, producing a growth premium rather than a value

premium.

The result presented in this section is intuitive, once we realize the similarities of growth and

disinvestment options with nancial options. The rm's investment opportunity is a call option

because the rm has the right, but not the obligation, to buy a unit of capital at a predetermined

price. As we know from the nancial options literature, as the price of the underlying security rises

and falls, the price of the call option rises and falls at a greater rate than the underlying security,

because the strike price of the call option acts like an implicit leverage. This suggests that the value

of the growth option, that is, the call option to invest, should be more responsive to protability

shocks, and hence riskier, than the assets-in-place. This is captured by c

1

¸ in this model.

This result is consistent with the nding of Bernardo, Chowdry, and Goyal (2007) that the beta of

28

growth opportunities is greater than the beta of assets-in-place for the unlevered rm. As a result,

growth rms, which derive their value mainly from growth options, should have higher expected

returns than value rms.

Similarly, the disinvestment opportunity is a put option, because the rm has the right, but not

the obligation, to sell a unit of capital at a predetermined price. The value of this put option is

negatively related to the value of the underlying asset, because the gain from exercising the option,

that is, from disinvestment, is higher for less productive rms. Therefore, the disinvestment option

provides the value rms with insurance against downside risk and hence reduces their riskiness. In

this model, this is captured via c

.

< 0.

This result is in contrast with the intuition of several recent papers, such as Zhang (2005) and

Cooper (2006), that present investment irreversibility as the source of the value premium. These

papers argue that investment adjustment costs make it harder for value rms to deploy their excess

capital when the economy faces bad shocks, whereas growth rms do not face the same problem,

as they do not have too much excess capital. As a result, assets-in-place should be riskier than

growth options and hence value rms should be riskier than growth rms. However, these papers

include xed operating costs in the prot function of the rm, which would affect the business risk,

possibly creating a value premium, as Carlson, Fisher, and Giammarino (2004) suggest.

13

To show that the relationship between investment irreversibility and the cross-section of stock

returns does not depend on the assumptions of the model, the following proposition generalizes the

13

Zhang (2005) provides (in Table IV) a sensitivity analysis that shows that a 10 percent reduction in xed operating

costs reduces the difference between stock returns of the rms in the highest and lowest book deciles by 1 percent.

If we assume that the elasticity of return differences to xed costs is constant, eliminating operating leverage should

lead to a 10 percent decrease in the value premium between the highest and lowest deciles and hence would nullify the

stock return differences.

29

argument that growth options are riskier than assets-in-place, by providing a proof that does not

depend on the properties of the adjustment cost or on the properties of the processes for productiv-

ity or the stochastic discount factor. The proposition focuses on total irreversibility of investment

because, if irreversibility were the main reason for the value premium, it would create the greatest

value premium if rms were not able to disinvest.

Proposition 6 In the absence of leverage and under perfect investment irreversibility, growth op-

tions are riskier than assets-in-place.

Proof. See Appendix

It follows from this proposition that growth rms that derive their value from growth options

should have higher expected returns, so we have a growth premium rather than a value premium

under investment irreversibility without leverage. Despite the negative relationship of the value

premium and investment irreversibility, I keep irreversibility in my model because it is useful to

generate a wide range of book-to-market values and market leverage that improves the model's t

with the data.

B. Financial Leverage and Stock Returns

Using Ito calculus and the Hamilton-Jacobi-Bellman equation (9) from the previous section, we

can write the expected excess stock return as

1 [d1

i

] :dt =

: (1

i

. A

i

) dt + 1 [dJ (1

i

. A

i

)]

J (1

i

. A

i

)

:dt = o

S

o

¹

A

i

J

iA

(1

i

. A

i

)

J

i

(1

i

. A

i

)

dt. (19)

30

where o

S

is the price of risk and o

¹

A

i

J

iX

(1

i

,A

i

)

J

i

is the risk exposure. The appendix shows that we

can rewrite this as

1

dt

1 (d1

i

) : =

_

1 +

:(/) ,:1

J

_

(¸:

¹1

+ c

1

:

G

+ c

.

:

1

) o

S

o

¹

. (20)

where the rst factor captures the Modigliani-Miller effect and the second factor decomposes the

total business risk (as if the rm were entirely nanced by equity) into assets-in-place, a growth

option, and a disinvestment option.

Financial leverage affects expected returns in two ways. The rst effect, the Modigliani-Miller

channel, is obvious in equation (20). Firms with higher market leverage, /1,J, also have higher

book-to-market values, (1 /) 1,J, when book leverage, /, is constant. This makes the equity of

rms with higher book-to-market value riskier.

The second effect comes from the interaction of nancial leverage and investment. We have

seen in Section IV that nancial leverage increases the effective degree of investment irreversibility

faced by the owners of the rm, and in Section V.A that irreversibility causes a growth premium,

rather than a value premium. Therefore, the effect of leverage on business risk, which is captured

by the second factor in equation (20), counteracts the Modigliani and Miller effect.

The net effect of leverage on expected stock returns depends on the parameterization of the

model, which we focus on next.

31

VI. Calibration and Simulation

Some parameters of the model have direct counterparts in the data. Accordingly, the tax rate is

taken to be 35 percent from Taylor (2003). The risk-free rate is taken to be 2 percent, using a time

series average of Fama's monthly T-bill returns from the CRSP database from July 1963 to June

2008. The yearly value of o

S

is set to 0.38 in order to match the average monthly Sharpe ratio of

the excess market return, using the excess market return series from Kenneth French's webpage,

again from July 1963 to June 2008. Because of the interaction between the resale price of capital

and book leverage, it is enough to preset only one of these parameters. Since there is no consensus

regarding the exact value of the resale price of capital, whereas we actually observe the book values

from Compustat, I preset book leverage to 0.5 and estimate the implied resale value of capital.

The remaining parameters for which we do not have direct observations are estimated via

maximum likelihood, using the long-run stationary distribution of the book-to-market values from

Compustat. It is possible to calibrate all the parameters using a collection of numbers from other

papers such as Zhang (2005), Cooper (2006), or Gomes and Schmid (2010), or to estimate the pa-

rameters that t the distribution of returns, as in Carlson, Fisher, and Giammarino (2004). Instead,

I make use of the distribution of book-to-market values, because explaining the cross-section of re-

turns consists of two important steps: getting the relationship between returns and book-to-market

values right and getting the distribution of book-to-market values right. If the model fails any of

these steps, it cannot produce the correct distribution of returns. Even worse, a model can claim to

explain the cross-section of returns correctly although it fails in both steps. Therefore, starting the

analysis with the distribution of book-to-market values provides a consistency check.

32

The appendix shows the derivation of the closed-form solution for the long-run stationary dis-

tribution of book-to-market values implied by the model. For estimation purposes, I make the

counterfactual assumption that book-to-market values are serially and cross-sectionally indepen-

dent and identically distributed, because the complex nature of the full information maximum

likelihood function would require resorting to simulated maximum likelihood, which would be

computationally expensive. Hayashi (2000, p. 465) shows that the resulting quasi-maximum like-

lihood estimator is indeed consistent. Therefore, it is a safe approach, given the high number of

rm-year observations in Compustat.

14

The resulting estimation values are presented in Table I, while Figure 4 gives the relationship

between conditional expected stock returns and the book-to-market values implied by the calibra-

tion. Indeed, we see that the Modigliani and Miller channel of leverage dominates the investment

channel, because the equity returns are increasing in book-to-market values.

Using this calibration, we can also immediately decompose the contribution of leverage to stock

returns through investment and the Modigliani-Miller channels. Figure 5 shows that introducing

debt has hardly any effect on business risk; hence the Modigliani-Miller channel easily dominates

the investment channel, as conrmed by Figure 4.

Using the parameter values in Table I, I simulate the model to obtain the statistics for various

book-to-market portfolios as in Fama and French (1992). Table II presents the simulation results

and the statistics obtained from the Compustat and CRSP data for the July 1963–June 2008 period.

This table shows that the simulated returns, book-to-market ratios, and market leverage are very

14

See Section 7.2 in Hayashi (2000), in particular the second remark on p.465. As in Fama and French (1992, Table

III), the smallest and largest 0.5% of the book-to-market ratios are winsorized.

33

3 2 1 1 2

logBM

10

20

30

40

Equity Returns in

Figure 4: Expected returns vs. book-to-market ratio using the estimated parameters.

34

Table I: Model parameters. The numbers in square brackets give 95 % condence intervals

calculated using 1000 bootstrap samples. Due to the large number of observations for book-to-

market value, the condence intervals are very tight. The productivity multiplier, /, affects the

levels of equity and debt but not the quantities we are interested in because these quantities depend

on the ratios, rather than levels. Hence, h is a free parameter and normalized to 1.

Model Parameters

Parameter Name Calibrated value Condence Interval

Interest Rate : 0.02

Price of Risk o

S

0.38

Corporate Tax t 0.35

Book Leverage / 0.50

Aggregate Volatility o

¹

0.14 [0.13,0.15]

Idiosyncratic Volatility o

i

0.51 [0.49,0.54]

Technology Drift j

A

-0.07 [-0.08,-0.06]

Maintenance Cost o 0.02 [0.0209,0.0249]

Capital Share in Production 1 ¸ 0.10 [0.1008,0.1035]

Resale/Purchase Value of Capital j 0.10 [0.1011,0.1022]

3 2 1 1 2

logBM

4

6

8

10

Unlevered Returns in

3.0 2.5 2.0 1.5 1.0 0.5 0.5

logBM

4

6

8

10

All Equity Returns in

Figure 5: Total yearly expected rm returns, debt and equity combined, for the levered rms

and all-equity nanced rms using estimated parameters.

35

Table II: Data versus simulation results with estimated parameters. Returns, BE/ME, ML, and

BL are time series averages of equally weighted cross-sectional means of equity returns, book-to-

market ratios, market leverage, and book leverage, respectively. These variables are dened in the

caption of Figure 1. The simulation results are the average of 200 simulations with 3000 rms and

1500 periods each. The rst 500 periods have been discarded to allow the system to converge to

its steady state. Using simulation results, the stocks are sorted according to their book-to-market

values in order to form 10 portfolios every month, as in Cooper (2006). Yearly sorting does not

change the results in a signicant way. The results are averages across simulations. Simulated

returns are adjusted upwards for ination. Columns 6 to 9 give benchmark model results; columns

10 and 11 give results when the maintenance cost, o, is changed from its benchmark value. Data

Source: CRSP and Compustat merged database, June 1963 to July 2008.

δ=0.01 δ=0.00

Portfolio Return BE/ME ML BL Return BE/ME ML BL Return Return

1 8.48 0.16 0.17 0.48 10.56 0.12 0.10 0.50 10.51 10.47

2 10.62 0.32 0.24 0.45 11.17 0.25 0.20 0.50 11.15 11.13

3 12.13 0.45 0.31 0.47 11.73 0.37 0.27 0.50 11.71 11.70

4 12.50 0.57 0.38 0.49 12.28 0.49 0.33 0.50 12.27 12.25

5 14.14 0.70 0.43 0.51 12.86 0.62 0.38 0.50 12.84 12.83

6 15.50 0.83 0.48 0.52 13.46 0.76 0.43 0.50 13.45 13.44

7 17.14 0.99 0.51 0.52 14.19 0.92 0.48 0.50 14.17 14.17

8 17.73 1.19 0.55 0.52 15.25 1.16 0.54 0.50 15.23 15.23

9 19.92 1.51 0.58 0.51 17.13 1.59 0.61 0.50 17.12 17.11

10 24.29 2.85 0.66 0.51 23.19 2.98 0.74 0.50 23.17 23.16

Data Model

36

close to the data, in accordance with the intuition presented in the paper: when book leverage is

relatively constant across different portfolios, value rms have higher leverage than growth rms;

hence, investing in the equity of value rms is riskier than investing in the equity of growth rms.

Moreover, the last two columns of Table II provide a sensitivity analysis for the maintenance

cost parameter, o, to support the claim that market leverage, and not operating leverage, is the main

driving force in the model because maintenance cost may cause an operating leverage channel as

in Carlson, Fisher, and Giammarino (2004). One might expect that stock returns will decrease as

the maintenance cost gets smaller because operating leverage increases the business risk. For ex-

ample, this is what we do observe in Zhang (2005). However, this intuition holds only if a change

in operating leverage does not affect the investment or nancing behavior of the rm. Indeed,

Zhang (2005) does not have any nancial leverage and investment decisions are independent of

operating leverage. In my model, given book leverage, a reduction in operating leverage decreases

the effective degree of investment irreversibility, the proof of which mirrors proposition 2, because

operating leverage increases the effective purchase and resale value of capital by the same amount.

Moreover, given investment behavior, a reduction in operating leverage also affects nancing be-

havior by increasing the debt capacity of the rms which in turn increases the equity risk. Table

II tells us that these effects counteract each other resulting in a small change in returns. Moreover,

the operating leverage parameter, which corresponds to my maintenance cost parameter, is equal

to 1.5 in Carlson, Fisher, and Giammarino (2004), whereas in my paper o = 0.02. which implies

that any effect of operating leverage should be much smaller in my paper, consistent with the result

in Table II.

37

Finally and not surprisingly, because this is a single factor model, the Capital Asset Pricing

Model (CAPM) ,s explain a signicant part of the variation in stock returns (not reported here).

This issue is addressed in the next section.

VII. Discussion

A. Failure of CAPM

One property of the model is that there is only a single systematic shock, and hence the conditional

CAPM holds. Although the unconditional version of the CAPM cannot explain perfectly the dif-

ferences in stock returns, it still explains a signicant fraction—more than what is predicted by the

data. This is a common property of the production-based models that try to explain cross-sectional

variation in stock returns with only one shock.

15

However, one reason the value premium is a puz-

zle is that it cannot be explained by the CAPM. Many investor-based models like the intertemporal

capital asset pricing model (ICAPM), as studied by Merton (1973), Campbell and Vuolteenaho

(2004), and Lettau and Wachter (2007), suggest that the CAPM fails because it does not price the

risk factors correctly when there are multiple aggregate shocks. The appendix shows that the ex-

tension of the model with shocks to the price of capital goods can easily generate a similar result

without changing any quantitative implications. The bottom line is that the leverage-based model

presented here does a very good job of capturing the distribution of returns and market leverage

across different book-to-market portfolios, whereas we can rely on additional macroeconomic fac-

15

Examples are Carlson, Fisher, and Giammarino (2004), Zhang (2005), and Berk, Green, and Naik (1999), among

others.

38

tors in order to generate the failure of the CAPM as in the studies above.

B. Fama-MacBeth Regressions

This section provides further empirical results in order to compare the implications of the model

with other previous studies that focus on the relationship between leverage and returns.

16

For

example, Johnson (2004) and Gomes and Schmid (2010) document a weak relationship between

market leverage and stock returns after accounting for book-to-market values.

17

Moreover, it is also

interesting to look at the relationship between stock returns and book leverage, although my model

is silent about this relationship since book leverage is constant in the model. In particular, Fama and

French (1992) document that book leverage is negatively related to stock returns after accounting

for market leverage, and Gomes and Schmid (2010) nd that the relationship between returns and

book leverage is weak before and after controlling for book-to-market values. In contrast to Gomes

and Schmid (2010), the results in George and Hwang (2010) seem to imply that book leverage

is negatively related to returns even after controlling for book-to-market values. This evidence

may seem contrary to the claim of the paper that market leverage is the main source of the value

premimum, at rst glance. In the following, I argue that this is not the case and, at the end, provide

an explanation that reconciles the claim with the evidence.

To study the relationship of returns with book-to-market values, market leverage, and book

16

I thank the anonymous referee for his comments that led to the development of this section.

17

A recent empirical study by Penman, Richardson, and Tuna (2006) nds that market leverage is negatively related

with equity returns after controlling for what they call the enterprise book-to-price ratio. However, their denition of

market leverage signicantly differs from Johnson (2004) and Gomes and Schmid (2010) because cash and short-term

investments are subtracted from nancial liabilities before calculating market leverage.

39

leverage in a unied framework I decompose book-to-market value into a market leverage and

a book leverage component. I stick to the denition of market and book leverage in Section I.,

which is similar to the denition in Gomes and Schmid (2010), to be consistent with the rest of the

analysis. Let ¹ be the book value of total assets, `1 the market value of equity, and 11 be the

book value of equity. Then, I can decompose the book-to-market ratio, 11,`1, as

11

`1

=

(¹ 11) , (`1 + ¹ 11)

`1, (`1 + ¹ 11)

11,¹

(¹ 11) ,¹

=

`1

1 `1

1 11

11

. (21)

where `1 and 11 are market and book leverage, respectively. Therefore, the value premium

should stem from either market leverage or book leverage. Note that the rst term on the right is

an increasing function of market leverage and the second term is a decreasing function of book

leverage.

This decomposition is somewhat different from Fama and French's (1992) decomposition,

11,`1 = (11,¹) (¹,`1), where ¹ is the book value of total assets. There is good rea-

son for this difference. Fama and French use ¹,11 as a measure of book leverage and ¹,`1 as

a measure of market leverage. While the ratio ¹,11 is clearly positively related with book lever-

age, the relationship between ¹,`1 and market leverage is not straightforward. In particular, we

can write ¹,`1 = (¹11),`1 +11,`1. The rst term, the ratio of debt to market value

of equity, is related to market leverage, as used in Gomes and Schmid (2010), for example. The

second term is the original book-to-market ratio. So, although ¹,`1 may be a good measure

40

Table III: Fama-MacBeth Regressions of stock returns on various variables. Book-to-market

value (BE/ME), market leverage (ML), and book leverage (BL) are dened in the caption of Figure

1. The coefcients are the time series average of regression coefcients for July 1963 to June 2008,

and the t-statistics (in parantheses) are the average regression coefcient divided by its time series

standard error. Note that some of the coefcients and t-statistics are similar to each other simply

because one variable is the sum of the other two. Each horizontal line is a separate regression.

log BE/ME log ML/(1-ML) log (1-BL)/BL

0.42 (6.38)

0.11 (2.61)

0.03 (0.69)

0.45 (8.12) -0.04 (1.14)

0.41 (6.39) 0.04 (1.14)

0.41 (6.39) 0.45 (8.13)

of market leverage, it includes more information than market leverage only. Instead, the terms

in my decomposition dissect the book-to-market ratio into its book leverage and market leverage

components completely.

Using this decomposition, I run all possible univariate and bivariate Fama-MacBeth regressions

of stock returns on the logarithms of 11,`1, `1, (1 `1) and (1 11) ,11. Table III

gives the results of these six regressions. The regression results are qualitatively the same when I

use Fama and French decomposition instead or when I run these regressions using log 11,`1,

log `1, and log 11, ignoring any decomposition. Adding rm size or the total returns over the

previous year do not change the regression results qualitatively, either.

Table III shows that while the sign of market leverage is positive and signicant in the univariate

41

regression, it becomes insignicant once we control for book-to-market value, as in Johnson (2004)

and Gomes and Schmid (2010). However, the lack of a statistically signicant coefcient on market

leverage after controlling for book-to-market value is not against the claim that market leverage is

the main source of the value premium. Suppose that the coefcient on market leverage remained

positive and statistically signicant after accounting for book-to-market value. This may only

imply that market leverage carries information about returns beyond what is captured in book-

to-market value. Moreover, the decomposition of book-to-market value into its market leverage

and book-leverage components suggests that the relationship between book-to-market value and

returns should stem either from market leverage or from book leverage. So, the question is which

of them drives the variation in stock returns (the value premium) and book-to-market values.

The unlevering exercise in Section I. already provides evidence for the importance of market

leverage in explaining the variation in stock returns across different book-to-market portfolios. For

the variation in book-to-market values, I look at the correlation of book-to-market value and its

components in the data. The time series average of the cross-sectional Spearman rank correlation

between book-to-market value and its market leverage component is 0.59 with standard deviation

0.07, whereas the rank correlation between book-to-market value and its book leverage component

is only 0.08 with standard deviation 0.09. Moreover, the time series average of the cross-sectional

Pearson correlation between the log of book-to-market value and its market leverage component

is 0.57 with standard deviation 0.06, whereas the Pearson correlation between the log of book-

to-market value and its book leverage component is only 0.02 with standard deviation 0.07. The

results are qualitatively the same when I use Fama and French's decomposition or log 11,`1,

42

log `1, and log 11, ignoring any decomposition. This evidence suggests that the market leverage

component is much more important than the book leverage component in explaining the variations

in book-to-market ratios. This analysis supports the idea that market leverage is the main driving

force behind the value premium.

The results for book leverage in Table III are in line with Gomes and Schmid (2010) and Fama

and French (1992). The coefcient for the book leverage component is small and insignicant be-

fore and after controlling for book-to-market value, which is supported by the analysis of Gomes

and Schmid (2010). Moreover, book leverage has a negative and signicant coefcient after con-

trolling for market leverage, as in Fama and French (1992). A striking result in the last regression is

that the coefcients of the market leverage and book leverage components are very similar in mag-

nitude, which seems to imply that the book-to-market effect wraps up any effect of market leverage

and book leverage. This result is also available in Fama and French (1992) with their decompo-

sition, presented in their Table III. So, the question becomes again, which of these components

accounts for more of the variation in book-to-market values and stock returns. As explained in

Section I., there is hardly any value premium left once the returns are unlevered and, as discussed

above, most of the variation in book-to-market values comes from the market leverage component.

Moreover, as illustrated below, the regression results presented so far can be consistent with the

book leverage component having no explanatory power for stock returns.

To see this last point more clearly, suppose that the correct model explaining returns is given

by :

1

= c

0

+ c

1

, + c, where c

0

and c

1

are coefcients, , is the fundamental factor, and c is the

error term with 1(c) = 0. Also, suppose that both book-to-market value and market leverage are

43

Table IV: Expected Values of Regression Coefcients

log 11,`1 log `1, (1 `1) log (1 11) ,11

,

·ov())

·ov())+·ov(&

1

)

,

·ov())

·ov())+·ov(&

2

)

0

,

·ov(&

2

)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

,

·ov(&

1

)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

,

·ov(&

1

)+·ov(&

2

)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

,

·ov(&1)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

,

·ov(&

1

)+·ov(&

2

)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

,

·ov(&

2

)

·ov(&

1

)+·ov(&

2

)+

var(u

1

)var(u

2

)

var(f)

imperfect proxies for this fundamental, so that log 11,`1 = , + n

1

and log `1, (1 `1) =

, +n

2

, where n

1

and n

2

are the measurement errors with respect to the original proxy, with 1(n

1

)

and 1(n

2

) constant, and 1(n

1

c) = 1(n

2

c) = co·(n

1

. n

2

) = 0. Finally, suppose that ·c: (n

1

) is

small relative to ·c:(n

2

), i.e., market leverage is subject to greater measurement error, which is

likely because, following the papers cited above, I approximate the market value of debt with the

book value of debt for the calculation of market leverage. Note that the book leverage component

would then be log (1 11) ,11 = log 11,`1 log `1, (1 `1) = n

1

n

2

and it would

be a random number completely unrelated to fundamentals. Table IV summarizes the expected

values of regression coefcients under this scenario. This scenario suggests that we should expect

the following results:

1. The book-to-market value and the market leverage component are highly correlated, whereas

the book-to-market value and the book leverage component have low correlation. Note that

the expected values of Pearson correlation coefcients are ·c: (,) ,

_

·c: (, + n

1

) ·c: (, + n

2

)

and ·c: (n

1

) ,

_

·c: (, + n

1

) ·c: (n

1

n

2

). respectively.

44

2. When we run two univariate regressions of returns on the book-to-market value and the mar-

ket leverage component separately, both regression coefcients should be expected to have

the same sign, but the coefcient of market leverage should be lower. (Regressions 1 and 2.)

We should also expect a small and insignicant coefcient when we run the regression of

returns on book leverage. (Regression 3.)

3. When we run the regression of returns on the book-to-market value and the market leverage

component, the coefcient on the book-to-market term should be large, whereas the coef-

cient on market leverage should be small. (Regression 4.) We should expect a similar pattern

when we replace market leverage with book leverage. (Regression 5.) The magnitude of the

coefcients on book leverage and market leverage should be smaller the smaller ·c: (n

1

) is

relative to ·c: (n

2

).

4. When we regress returns on the market leverage and book leverage components, both of

them should be large and have similar magnitude. (Regression 6.) The magnitude of the two

coefcients become closer the lower ·c:(n

1

) is relative to ·c: (n

2

).

All these items are in line with the regression results in Table III and the correlations discussed

before. Finally, this argument also sheds light on why we see constant average book leverage across

different book-to-market portfolios, as seen in Figure 1: As the sample size increases, the average

value of the book leverage component in each portfolio approaches the constant 1(n

1

n

2

) by the

law of large numbers.

So, the results presented in this section are compatible with an explanation where book-to-

45

market value and market leverage proxy for the same fundamental factor, despite that the book-

to-market proxy is subject to less error. Therefore, the regression results above do not refute the

hypothesis that market leverage is the main source of the value premium but actually are consistent

with the idea that market leverage and book-to-market value proxy for the same source of risk.

These results also suggest that book leverage is not necessarily related to book-to-market value

and stock returns systematically. Although book leverage is constant in the model, it is possible to

introduce cross-sectional variation in book leverage to the model, for example, by assuming that

some of the model parameters are rm or industry specic or by introducing an idiosyncratic shock

to a model parameter, such as the resale value of capital, j. This would not change the main results

of the paper, although it would make it harder to derive closed-form solutions and the resulting

clear intuition provided in this paper.

VIII. Conclusion

This paper presents a dynamic model of the rm with limited capital irreversibility and risk-free

debt contracts in order to analyze the effects of nancial leverage on investment and explain the

positive relationship between book-to-market values and stock returns. This model can capture sev-

eral regularities in the corporate nance and asset pricing literature in a parsimonious and tractable

way.

The model also suggests testable implications: The effect of nancial leverage on returns

through the investment channel implies that rms with a greater interest tax-shield invest as if

46

they faced greater investment irreversibility. Moreover, the model also suggests that industries

with a higher degree of investment irreversibility, corrected for the interest tax shield and leverage,

should have a weaker relationship between book-to-market values and stock returns. One can po-

tentially test these implications of the model by comparing the investment behavior and the value

premium in industries with different corrected investment irreversibility. Cohen and Polk (1998)

show that the value premium is a within-industry, rather than an inter-industry phenomenon, so

this would be a valid test.

Introducing debt into production-based asset pricing models opens several possibilities. For

example, the model presented here could be extended with time-varying interest rates in a frame-

work similar to Merton's (1973) intertemporal capital asset pricing model (ICAPM). This would

serve two purposes. First, it would decrease the explanatory power of the conditional market beta

for stock returns and get us one step closer to solving the value premium puzzle. Second, because

rms with a high book-to-market ratio also have higher leverage, they will have greater exposure

to interest rate shocks, further reinforcing the value premium. This is left for future research.

47

Appendix

A. Boundary Conditions

This section presents the boundary conditions for the HJB equation 9.

18

The boundary conditions

at the investment boundary, A

l

(1. /), are

J

1

(1. A

l

(1. /) . /) = 1 / (22)

J

11

(1. A

l

(1. /) . /) = 0 (23)

J

1A

(1. A

l

(1. /) . /) = 0 (24)

J

1b

(1. A

l

(1. /) . /) = 1. (25)

while the boundary conditions at the disinvestment boundary, A

1

(1. /), are given by

J

1

(1. A

1

(1. /) . /) = j / (26)

J

11

(1. A

1

(1. /) . /) = 0 (27)

J

1A

(1. A

1

(1. /) . /) = 0 (28)

J

1b

(1. A

1

(1. /) . /) = 1. (29)

18

Dixit (1993) is a good introduction to the derivation of these conditions.

48

Finally, if we denote the book leverage after adjustment as /

0

, the boundary conditions at the debt

adjustment boundaries

19

are given by

J (1. A

1

(1. /) . /) = J (1. A

1

(1. /) . /

0

) + (/

0

/) 1 c/

0

1 (30)

J

1

(1. A

1

(1. /) . /) c/ = J

1

(1. A

1

(1. /) . /

0

) + (/

0

/) c/

0

(31)

J

A

(1. A

1

(1. /) . /) = J

A

(1. A

1

(1. /) . /

0

) (32)

J

b

(1. A

1

(1. /) . /) = 1 (33)

(1 c)1 J

b

(1. A

1

(1. /) . /

0

) . (34)

The last of these conditions is the rst-order condition with respect to after-adjustment leverage, /

0

,

under the debt constraint. Hence, it holds as an equality if the new book leverage satises /

0

< j or

J (1. A. /

0

) 0, depending on the constraint imposed by the lender. The market value of equity,

J (A. 1. /), should be homogeneous of degree one in 1 and A, because the cash ows and the

adjustment costs on debt and investment are homogeneous in 1 and A.

20

Equation (30) says that, at the time of debt adjustment, the net shareholder value before and

after adjustment should be the same. If the shareholder value before adjustment were greater,

adjusting debt would harm the shareholders. If the shareholder value before adjustment were

lower, continuity of equity value in its arguments would imply that shareholders could gain from

19

There are potentially two adjustment boundaries for upward or downward adjustment. However, since the cost of

adjustment is the same in both cases, the boundary conditions are the same.

20

This argument is similar to the one in Abel and Eberly (1996) and Cooper (2006). To justify this homogeneity

property and hence that X=K is a sufcient statistic to describe the solution of the model, the reader can directly sub-

stitute in V (y; b) V (X=K; b) = J (X; K; b) =K and see that both the HJB equation and the boundary conditions

can be expressed in terms of V (y; b) and its derivatives.

49

adjustment prior to the specied adjustment time and hence the suggested adjustment time cannot

be optimal.

Equations (31) to (33) state that, at the time of adjustment, the shareholder value should be

differentiable with respect to the state variables. Intuitively, we can think of these smooth pasting

conditions as envelope conditions. To see this more clearly, note that /

0

is chosen such that the

right side of equation (30), i.e., the net shareholder value after adjustment, is maximized, and this

maximized shareholder value should be equal to before-adjustment shareholder value, that is,

J(1. A. /) = max

b

0

J(1. A. /

0

) + (/

0

/)1 c/

0

1 (35)

subject to /

0

j.

Using the envelope theorem, we can take the derivatives of both sides with respect to 1, A, and

/ and replace A = A

1

(1. /) to get equations (31) to (33). Therefore, according to the envelope

theorem, equations (31) to (33) yield the amount the shareholders should be compensated ex-ante

if capital K, productivity X, and before-adjustment book leverage, respectively, increase by a small

amount. Equation (34) is simply the rst-order condition of this last maximization problem and

states that the marginal gain from adjustment should be equal to or greater than the marginal loss

fromadjustment, because of the constraint /

0

j. Debt adjustment occurs if/when these optimality

conditions are satised.

50

B. Market Value and Stock Returns with Irreversibility and Financial Lever-

age

We can simplify our problem by dening ~ ¡ (¸. /) ¡ (¸. /) + :,:. Therefore, equations (11),

(13), and (12) can be rewritten as

:~ ¡ (¸. /) =

/¸

¸

+ j¸~ ¡

j

(¸. /) +

1

2

o

2

¸

2

~ ¡

jj

(¸. /) (36)

~ ¡ (¸

1

(/) . /) = j / + :(/) ,: | (/) and ~ ¡

j

(¸

1

(/) . /) = 0 (37)

~ ¡ (¸

l

(/) . /) = 1 / + :(/) ,: n(/) and ~ ¡

j

(¸

l

(/) . /) = 0. (38)

This makes the solution of the differential equation similar to the one in Abel and Eberly

(1996), which is a special case of my model that excludes leverage and the risk preferences of

investors. Following their analysis, I dene the following functions

j (r) =

1

2

o

2

r

2

_

j

1

2

o

2

_

r + : (39)

o (r) =

r

c

P

r

¸

r

c

P

r

c

N

(40)

c(r) =

1

j (¸)

_

1

¸

c

.

o (r)

¸

c

1

[1 o (r)]

_

. (41)

where c

1

and c

.

are the roots of the quadratic equation j (r) = 0 and satisfy c

1

1 ¸ 0

c

.

, given that we require : j for the convergence of solution to the rm's problem. Then, the

51

solution of this differential equation should be of the form

~ ¡ (¸. /) = H¸

¸

+ C

1

(/) ¸

c

P

+ C

.

(/) ¸

c

N

. (42)

The reason is that / appears only in the boundary conditions for ~ ¡ but not in the differential equa-

tion.

Dene H (¸)

/,j (¸) and G(/) ¸

l

(/) ,¸

1

(/). Then, the solution of the differential

equation for ~ ¡ (¸. /) is given by

21

~ ¡ (¸. /) = H (¸) ¸

1

(/)

¸

__

¸

¸

1

(/)

_

¸

¸

c

1

[1 o (G(/))]

_

¸

¸

1

(/)

_

c

P

¸

c

.

o (G(/))

_

¸

¸

1

(/)

_

c

N

_

. (43)

where G(/) is implicitly dened by

n(/)

| (/)

c(G(/)) G(/)

¸

c(1,G(/)) = 0 (44)

and the values of boundaries are given by

/¸

l

(/)

¸

=

n(/)

c(1,G(/))

and

/¸

1

(/)

¸

=

| (/)

c(G(/))

. (45)

Using this solution, the value function can be found by simply integrating ¡ (A,1) over 1 to

21

The solution is identical to that of Abel and Eberly (1996) once the purchase and resale prices of capital in their

model are substituted with u(b) and l (b), respectively. Therefore, I omit the lengthy details of the calculus that leads

to the solution, but they are available upon request.

52

get

22

J (1. A. /)

= H (¸) ¸

¸

1

_

1

1 ¸

A

¸

1

1¸

¸

1

(/)

¸

¸

c

1

1 o (G)

1 c

1

A

c

P

1

1c

P

¸

1

(/)

c

P

¸

c

.

o (G)

1 c

.

A

c

N

1

1c

N

¸

1

(/)

c

N

_

:(/)

:

1

=

HA

¸

1

1¸

+

1

1

(/) A

c

P

1

1c

P

+

1

.

(/) A

c

N

1

1c

N

:(/)

:

1

= J

¹1

+ J

G

+ J

1

:(/)

:

1. (46)

where J

¹1

is the value of assets in place, before costs, J

G

is the value of growth options, J

1

is the value of the disinvestment option, and :(/) ,:1 is the present value of maintenance and

nancing costs. Note that the derivation of the market value of equity does not make use of the

boundary conditions for debt restructuring. The book leverage, /, is constant in the inaction region

due to debt adjustment costs. Therefore, any effect of debt adjustment on market value of equity

should be captured by constants of integration

1

1

(/) and

1

.

(/) and hence we do not have a

separate term for debt adjustment option. The analysis here shows that the boundary conditions

for investment are enough to pin down these constants of integration.

Now we focus on stock returns. Apply Ito's Lemma to equity value in the inaction region,

J (1. A)

dJ =

_

j

A

AJ

A

+

1

2

o

2

A

2

J

AA

_

dt + oAJ

A

dn. (47)

22

Direct integration of q (y) would yield a constant of integration that should have the form D

X

(b) X, due to the

homogeneity property of the value function. However, direct substitution of J (X; K) into the HJB equation shows

immediately that D

X

(b) should be zero.

53

Use the relationship j = j

A

o

S

o

¹

and the HJB equation :J = : +jAJ

A

+

1

2

o

2

A

2

J

AA

to get

1

dt

1

_

dJ

J

_

=

:

J

+ : + o

S

J

A

A

J

. (48)

Plugging this expression into the return formula gives the excess returns

1

dt

1 (d1) : =

1

dt

1

_

:dt + dJ

J

_

: = o

S

o

¹

J

A

A

J

. (49)

To show that the returns are increasing in ¸, rst note that we can write the excess returns as

1

dt

1 (d1) : =

_

¸

J

¹1

J + :,:1

+ c

1

J

G

(1. A)

J + :,:1

+ c

.

J

1

(1. A)

J + :,:1

__

1 +

:,:1

J

_

o

S

o

¹

= (¸:

¹1

+ c

1

:

G

+ c

.

:

1

)

_

1 +

:,:1

J

_

o

S

o

¹

. (50)

where the rst term decomposes the total business risk into assets-in-place, the growth option and

the disinvestment option, while the second term captures the Modigliani-Miller effect.

C. Proof of Proposition 2

We can rewrite equation (44) as

n(/)

| (/)

=

G(/)

¸

c(1,G(/))

c(G(/))

. (51)

54

Here, n(/) ,| (/) captures the degree of irreversibility perceived by the shareholders and G(/)

¸

l

(/) ,¸

1

(/) captures the gap between the investment and disinvestment boundaries. It is easy to

show that the left side of this equation is increasing in /, and hence the right side of the equation

should be increasing in /. Abel and Eberly (1995) show in a lengthy and tedious proof that

G

ç(1¸G)

ç(G)

is increasing in G. Suppose G

0

(/) 0. Then, the left side would be weakly decreasing in /,

causing a contradiction.

D. Proof of Proposition 3

Debt is strictly preferable to equity nancing if the marginal value of debt net of the cost of nanc-

ing is positive, that is if J (1. A. /) +/1c/1 is increasing in / or J

b

(1. A. /) +(1 c) 1 0.

We should rst nd J

b

(1. A. /). Remember that the market value of equity has the form

J (1. A. /) =

HA

¸

1

1¸

+

1

1

(/) A

c

P

1

1c

P

+

1

.

(/) A

c

N

1

1c

N

:(/)

:

1. (52)

Because

1

1

(/) and

1

.

(/) are highly non-linear functions of / and because G(/) is an implicitly

dened function, a brute force approach would be too tedious. Instead, we focus on the value-

matching and smooth pasting conditions. Using the functional formand homogeneity of the market

value of equity in A and 1, the value-matching conditions for the marginal value of capital can be

55

expressed as

H¸

l

(/)

¸

+ (1 c

1

)

1

1

(/) ¸

l

(/)

c

P

+ (1 c

.

)

1

.

(/) ¸

l

(/)

c

N

= 1 t/ + (1 t)

o

:

(53)

H¸

1

(/)

¸

+ (1 c

1

)

1

1

(/) ¸

1

(/)

c

P

+ (1 c

.

)

1

.

(/) ¸

1

(/)

c

N

= j t/ + (1 t)

o

:

(54)

and the smooth-pasting conditions can be expressed as

H¸¸

l

(/)

¸

+ (1 c

1

) c

1

1

1

(/) ¸

l

(/)

c

P

+ (1 c

.

) c

.

1

.

(/) ¸

l

(/)

c

N

= 0 (55)

H¸¸

1

(/)

¸

+ (1 c

1

) c

1

1

1

(/) ¸

1

(/)

c

P

+ (1 c

1

) c

.

1

.

(/) ¸

1

(/)

c

N

= 0. (56)

If we take the derivatives of equations (53) and (54) with respect to / and plug equations (55)

and (56) in the resulting expressions we get

(1 c

1

)

1

0

1

(/) ¸

l

(/)

c

P

+ (1 c

.

)

1

0

.

(/) ¸

l

(/)

c

N

= t (57)

(1 c

1

)

1

0

1

(/) ¸

1

(/)

c

P

+ (1 c

.

)

1

0

.

(/) ¸

1

(/)

c

N

= t. (58)

56

which gives

1

0

1

(/) =

t

1 c

1

1 G(/)

c

N

G(/)

c

P

G(/)

c

N

1

¸

1

(/)

c

P

(59)

1

0

.

(/) =

t

1 c

.

G(/)

c

P

1

G(/)

c

P

G(/)

c

N

1

¸

1

(/)

c

N

. (60)

As a result, the derivative of market value of equity with respect to leverage is given by

J

b

(1. A. /) = t

_

1 G

c

N

G

c

P

G

c

N

1

1 c

1

_

¸

¸

1

_

c

P

+

G

c

P

1

G

c

P

G

c

N

1

1 c

.

_

¸

¸

1

_

c

N

+

1 t

t

_

1.

(61)

where / has been dropped in G(/) for the sake of brevity. Therefore the marginal value of debt is

given by

J

b

+ (1 c) 1 = t

_

1

1 G

c

N

G

c

P

G

c

N

1

1 c

1

_

¸

¸

1

_

c

P

G

c

P

1

G

c

P

G

c

N

1

1 c

.

_

¸

¸

1

_

c

N

_

1

c1. (62)

Since G 1 and c

1

1 0 c

.

, the term in square brackets is increasing in ¸. Therefore,

debt is the preferred form of nancing at every state if J

b

+ (1 c) 1 0 at ¸ = ¸

1

. Substituting

¸ = ¸

1

above reduces our condition to

c < c

(/) = t

_

1

1 G

c

N

G

c

P

G

c

N

1

1 c

1

G

c

P

1

G

c

P

G

c

N

1

1 c

.

_

. (63)

Since G 1 and c

1

1 0 c

.

, the second term is on the right side is negative and the third

57

term is less than 1. Moreover, the right side of this equation is decreasing in G, and we already

knowfromthe proof of the previous proposition that G

0

(/) 0. Therefore, c

(/) 0 and c

0

(/) <

0. The minimum for c

(/) is then attained when G !1, that is, c

= 1 1, (1 c

.

). So, if c <

1 1, (1 c

.

), then debt is always preferable regardless of state and degree of irreversibility.

E. Proof of Proposition 4

From equation (62) we have

J

b

+ 1 = t

_

1

1 G

c

N

G

c

P

G

c

N

1

1 c

1

_

¸

¸

1

_

c

P

G

c

P

1

G

c

P

G

c

N

1

1 c

.

_

¸

¸

1

_

c

N

_

1. (64)

which attains its minimum value for ¸ = ¸

1

. So, it is enough to show that this value is positive

once we substitute ¸ = ¸

1

, i.e. that

t

_

1

1 G

c

N

G

c

P

G

c

N

1

1 c

1

G

c

P

1

G

c

P

G

c

N

1

1 c

.

_

0. (65)

Again, since G 1 and c

1

1 0 c

.

, the second term on the right side is negative and

the third term is less than 1. Therefore, the term in square brackets should be positive. Since

J

b

+ 1 0, one of the smooth pasting conditions at debt adjustment is not satised, and hence it

is not optimal to readjust debt.

58

F. Market Value and Stock Returns with Investment Irreversibility Only

The market value of equity under this setting is the same, except that we should set / = o = 0. Let

H (¸) /,j (¸) and G ¸

l

,¸

1

. Then, the solution of the differential equation for ¡ (¸) where

¸ A,1 is given by

¡ (¸) = H (¸) ¸

¸

1

__

¸

¸

1

_

¸

¸

c

1

[1 o (G)]

_

¸

¸

1

_

c

P

¸

c

.

o (G)

_

¸

¸

1

_

c

N

_

. (66)

where G is the solution of

1

j

c(G) G

¸

c

_

G

1

_

= 0. (67)

Using this solution, the value function can be found by simply integrating ¡ (A,1) over 1 to get

23

J (1. A)

= H (¸) ¸

¸

1

_

1

1 ¸

A

¸

1

1¸

¸

¸

1

¸

c

1

1 o (G)

1 c

1

A

c

P

1

1c

P

¸

c

P

1

¸

c

.

o (G)

1 c

.

A

c

N

1

1c

N

¸

c

N

1

_

= J

¹1

+ J

G

+ J

1

. (68)

23

Direct integration of q (y) would yield a constant of integration that should depend linearly on X due to the

homogeneity property of the value function. However, direct substitution of J (X; K) into the HJB equation shows

immediately that this term should be zero.

59

To show that the returns are increasing in ¸, rst note that we can write the excess returns as

1

dt

1 (d1) : =

_

¸

J

¹1

(1. A)

J (1. A)

+ c

1

J

G

(1. A)

J (1. A)

+ c

.

J

1

(1. A)

J (1. A)

_

o

S

o

¹

=

_

¸

J

¹1

(1. ¸)

J (1. ¸)

+ c

1

J

G

(1. ¸)

J (1. ¸)

+ c

.

J

1

(1. ¸)

J (1. ¸)

_

o

S

o

¹

=

_

¸ + (c

1

¸)

J

G

(1. ¸)

J (1. ¸)

+ (c

.

¸)

J

1

(1. ¸)

J (1. ¸)

_

o

S

o

¹

. (69)

Now, it is easy to show that J

G

(1. ¸) ,J (1. ¸) is increasing in ¸ and J

1

(1. ¸) ,J (1. ¸) is decreas-

ing in ¸ by taking the derivatives. Since c

1

¸ 0 and c

.

¸ < 0, this last expression should be

increasing in ¸. Book-to-market value is equal to J(1. A),1 = J(1. ¸) with ¸ = A,1. More-

over, J(1. A) is increasing in A since a rm with higher productivity should have higher market

value, given capital. Hence J

j

(1. ¸) = J

A

(1. A) 0 and book-to-market is decreasing in ¸. As

a result, returns should be decreasing in book-to-market.

G. Proof of Proposition 6

In case of perfect irreversibility the rm does not have a disinvestment option. Therefore, the

market value of equity consists of the value of growth options and assets-in-place only. If we let

:

¹1

be the return on assets in place and :

G

be the return on the growth option, we can write the

expected returns to equity as

:

1

=

J

¹1

(1. A)

J (1. A)

:

¹1

+

J

G

(1. A)

J (1. A)

:

G

. (70)

60

where

J (1. A) = J

¹1

(1. A) + J

G

(1. A) (71)

:

1

=

J

A

J

¸

¸

¸

¸

co·

_

dA.

do

o

_¸

¸

¸

¸

(72)

:

¹1

=

J

¹1

A

J

¹1

¸

¸

¸

¸

co·

_

dA.

do

o

_¸

¸

¸

¸

(73)

:

G

=

J

G

A

J

G

¸

¸

¸

¸

co·

_

dA.

do

o

_¸

¸

¸

¸

. (74)

Moreover, given capital, rms with higher productivity have lower book-to-market values, and

hence are growth rms, for which the growth options constitute a greater share of market value.

Therefore, we should have

JJ

G

(1. A) ,J (1. A)

JA

0. (75)

With a little algebra, we can show that

JJ

G

(1. A) ,J (1. A)

JA

=

J

G

(1. A) ,J (1. A)

¸

¸

co·

_

dA.

oS

S

_¸

¸

(:

G

:

1

) . (76)

which together with (70) and (75) implies that :

G

:

1

:

¹1

. Therefore, growth options are

riskier than assets-in-place.

H. The Long-Run Distribution of Book-to-Market Values

In this section we calculate the stationary long-run distribution of book-to-market values. I assume

that a rm leaves the sample if ¸ = ¸

¸

1

. This assumption serves two purposes: First, rms

61

with very low market values will leave the sample, in accordance with the Security Exchange

Commission rule that requires delisting of companies whose share price falls below a certain value

or for performance-related reasons. Second, because this assumption caps book-to-market values,

it will improve the t of the average book-to-market values and stock returns at the highest decile.

In order to have a stationary distribution, I also assume that each rm that leaves the stock mar-

ket is replaced by another rm that enters the market after paying a xed cost linearly proportional

to its capital. This later assumption guarantees that the entry point for all rms is the same and is

characterized by ¸ = ¸, as a result of the homogeneity of the maximization problem in A and 1.

24

Using the model parameters, we can calculate the cross-section of returns in the long run by

looking at the stationary distribution of ¸ between two barriers, ¸

and ¸

l

. The exit-entry mecha-

nism discussed above implies that the long-run cross-sectional distribution of ¸ will be the same as

the long-run distribution of a process with a resetting barrier at ¸

**. where the target after resetting
**

is ¸. Note that the case without exit is a special case of this mechanism, where ¸ = ¸

l

and ¸

= ¸

1

.

and the no-entry-cost is a special case with ¸ = ¸

= ¸

1

.

The law of motion for ¸ between barriers is given by d¸,¸ = j

A

dt + odn. Dene . log ¸,

.

log ¸

, and .

l

log ¸

l

, and let q (.) be the long-run distribution of .. Bertola and Cabellero

(1990) show that q (.) is given by the solution of the Kolmogorov forward equation

q

00

(.) = 2

_

j

A

1

2

o

2

_

o

2

q

0

(.) (77)

24

The same entry point is a simplifying assumption. Different entry points would not affect the functional form for

the market value of equity, since debt capacity is independent of the state variables.

62

separately for the regions [.

. .) and ( .. .

l

] with the following boundary conditions

q

0

_

.

_

= q

0

_

.

+

_

+ q

0

_

.

+

_

(78)

q

0

(.

l

) = 2

_

j

A

1

2

o

2

_

o

2

q (.

l

) (79)

q (.

) = 0. (80)

where q (.

+

) is the right limit and q (.

**) is the left limit of the distribution function. We also have
**

the integral condition

_

:

U

:

q (.) d. = 1. (81)

Once we nd q (.), we can nd the distribution of ¸ using the transformation ,(¸) = q (ln ¸) ,¸.

A little algebra shows that the long-run distribution of ¸ is given by

,(¸) =

_

¸

¸

¸

¸

¸

_

¸

¸

¸

¸

¸

_

_

¹

1

¸

(2j

X

o

2

)¸o

2

+ 1

1

_

,¸ if ¸

< ¸ < ¸

¹

2

¸

(2j

X

o

2

)¸o

2

1

if ¸ ¸ < ¸

l

0 otherwise.

(82)

63

where ¹

1

. ¹

2

and 1

1

satisfy

0 = (¸

)

(2j

X

o

2

)¸o

2

¹

1

+ 1

1

(83)

0 =

_

¸

(2j

X

o

2

)¸o

2

(¸

)

(2j

X

o

2

)¸o

2

_

¹

1

¸

(2j

X

o

2

)¸o

2

¹

2

(84)

1 =

¸

(2j

X

o

2

)¸o

2

(¸

)

(2j

X

o

2

)¸o

2

(2j

A

o

2

) ,o

2

¹

1

+

¸

(2j

X

o

2

)¸o

2

l

¸

(2j

X

o

2

)¸o

2

(2j

A

o

2

) ,o

2

¹

2

+ln

_

¸

¸

_

1

1

. (85)

Then, we can write market-to-book values as J, (1 /) 1 = \ (¸) , (1 /). Once we dene

the function . (¸) = \ (¸) , (1 /), the long-run distribution of market-to-book values, :/, is

given by

, (:/) = ,

_

.

1

(:/)

_

¸

¸

¸

¸

d.

1

(:/)

d (:/)

¸

¸

¸

¸

(86)

for \ (¸

l

) , (1 /) :/ \ (¸

1

) , (1 /), and zero otherwise.

Once we have the long-run distribution of market-to-book values, I use the long-run distribution

derived from the data in order to estimate the model parameters using maximum likelihood.

I. Time-Varying Price of Capital

I assume that the price of capital follows a geometric Brownian motion,

25

that is,

d1

t

1

t

= j

1

dt + o

1

dn

1

. (87)

25

For example, this process may come from a perfectly competitive industry that produces capital goods, with a

linear production function subject to technology shocks that follow a geometric Brownian motion.

64

For this process, j

1

< 0 implies that increasing the capacity becomes cheaper over time, creating

a vintage capital effect. We can write the problem of the rm as

\(1

t

.

^

A

t

. 1

t

) = max

fol

t+s

,o1

t+s

,ob

t+s

g

1

t

_

1

0

o

t+c

o

t

_

1

t+c

.

^

A

t+c

. 1

t+c

_

d:

_

1

0

o

t+c

o

t

[(1 /)1

t+c

dl

t+c

(j /) 1

t+c

d1

t+c

]

+

1

c2fc:ob

t+s

6=0g

o

t+c

o

t

[d/

t+c

c(/

t+c

+ d/

t+c

)] 1

t+c

1

t+c

(88)

subject to

d1

t

= dl

t

d1

t

(89)

do

t

o

t

= :dt o

S¹

dn

¹,t

+ o

S1

dn

1,t

(90)

d

^

A

t

^

A

t

= j

¹

dt + o

¹

dn

¹,t

+ o

i

dn

i,t

(91)

d1

t

1

t

= j

1

dt + o

1

dn

1,t

. (92)

where

_

1

t

.

^

A

t

. 1

t

_

(1 t)

_

/

1 ¸

^

A

t

1

1¸

t

o1

t

1

t

:/1

t

1

t

_

+ ^ j

1

/1

t

1

t

. (93)

The new term ^ j

1

/1

t

1

t

appears because of the changes in the amount of debt as a result of changes

in the price of capital, where ^ j

1

= j

1

+ o

S1

o

1

is the risk-adjusted drift of the price process.

Intuitively, operating capital acts as an asset that provides an instantaneous return of d1,1 as a

65

result of the debt agreement and price movements and ^ j

1

is the risk-adjusted value of this return.

I assume that the risk prices of

^

A and 1 have opposite signs, because good times are characterized

by higher productivity and lower input prices.

Note that this problem is linearly homogeneous in

^

A

t

and 1

t

, since both variables follow a

geometric Brownian motion and enter linearly into the problem. Therefore, I can divide everything

by 1

t

and dene A

¸

t

^

A

t

,1

t

, : (1. A) (1.

^

A. 1),1 and J (1. A) \(1.

^

A. 1),1. This

will give us the following Hamilton-Jacobi-Bellman equation in the inaction region

(: ^ j

1

) J = : (1. A) + jAJ

A

+

1

2

o

2

A

2

J

AA

. (94)

where

j =

1

¸

(^ j

¹

^ j

1

) +

1

2

_

1

¸

1

_

1

¸

_

o

2

1

+ o

2

¹

+ o

2

i

_

(95)

o

2

=

1

¸

2

_

o

2

1

+ o

2

¹

+ o

2

i

_

(96)

with ^ j

¹

= j

¹

o

S¹

o

¹

. This Bellman equation is very similar to the Bellman equation in the orig-

inal model, and the boundary conditions are identical. As a result of this close relationship with

the original model, all the analysis for the original model holds for this extended version. In partic-

ular, any investment and nancing policy, distribution of book-to-market values, and stock returns

under the original model can be replicated under the extended version. However, the behavior of

the conditional CAPM will change signicantly. We focus on this in the next sections.

66

I..1 Stock Returns

In this section I provide the expressions of individual stock returns, denoted by i, and of the value-

weighted market return in order to analyze the relationship of actual conditional expected returns

with those implied by the CAPM. It can be shown that the equity returns in this extended version

are given by

d1

i

=

_

: + o

S¹

o

¹

\

i

^

A

^

A

i

\

i

o

S1

o

1

\

i1

1

\

i

_

dt

+

\

i

^

A

^

A

i

\

i

(o

¹

dn

¹

+ o

i

dn

i

) +

\

i1

1

\

i

o

1

dn

1

. (97)

Due the homogeneity of \(1.

^

A. 1) in

^

A and 1, we have

W

iP

1

W

i

=

_

1

W

i

^

X

^

A

i

W

i

_

. Using this

and the denition of J, we can write the last equation as

d1

i

=

_

: + o

S¹

o

¹

J

iA

A

i

¸J

i

o

S1

o

1

_

1

J

iA

A

i

¸J

i

__

dt

+

J

iA

A

i

¸J

i

(o

¹

dn

¹

+ o

i

dn

i

) +

_

1

J

iA

A

i

¸J

i

_

o

1

dn

1

. (98)

Note that, similar to the original model, the effect of book-to-market value is captured by the

elasticity of the market value of equity with respect to productivity shocks J

iA

A

i

,J

i

.

Using individual stock returns, we can derive the market return as

d1

n

=

_

: + o

S¹

o

¹

_

i

A

i

J

iA

(1

i

. A

i

) di

¸

_

i

J

i

(1

i

. A

i

) di

o

S1

o

1

_

1

_

i

A

i

J

iA

(1

i

. A

i

) di

¸

_

i

J

i

(1

i

. A

i

) di

__

dt

+

_

i

A

i

J

iA

(1

i

. A

i

) di

¸

_

i

J

i

(1

i

. A

i

) di

o

¹

dn

¹

+

_

1

_

i

A

i

J

iA

(1

i

. A

i

) di

¸

_

i

J

i

(1

i

. A

i

) di

_

o

1

dn

1

. (99)

67

I..2 Market Beta and Failure of the Conditional CAPM

Using the individual rm and value-weighted market returns presented above, I will show the

failure of the conditional CAPM. For the sake of simplifying the notation, dene

n

=

_

i

A

i

J

iA

(1

i

. A

i

) di

¸

_

i

J

i

(1

i

. A

i

) di

(100)

i

=

J

iA

A

i

¸J

i

. (101)

Using the formulas above, we can calculate the conditional market beta as

,

i

=

co· (d1

n

. d1

i

)

·c: (d1

n

)

=

i

n

o

2

¹

+ (1

i

) (1

n

) o

2

1

2

n

o

2

¹

+ (1

n

)

2

o

2

1

. (102)

Then, the expected instantaneous return implied by the conditional CAPM is not equal to condi-

tional expected returns, that is,

,

i

1 [d1

n

:dt] =

i

n

o

2

¹

+ (1

i

) (1

n

) o

2

1

2

n

o

2

¹

+ (1

n

)

2

o

2

1

[

n

(o

S¹

o

¹

+ o

S1

o

1

) o

S1

o

1

] dt

6= [

i

(o

S¹

o

¹

+ o

S1

o

1

) o

S1

o

1

] dt = 1 [d1

i

:dt] . (103)

which implies the failure of the conditional CAPM.

More interestingly, it is possible that a rm with higher returns has a lower beta. To see this,

68

rewrite beta as

,

i

=

i

[

n

(o

2

¹

+ o

2

1

) o

2

1

] + (1

n

) o

2

1

2

n

o

2

¹

+ (1

n

)

2

o

2

1

. (104)

While the expected return is increasing in

i

(which leads to a value premium) we have J,

i

,J

i

<

0 if o

2

¹

,o

2

1

< (1

n

) ,

n

, which holds when

n

is sufciently small. Note that

R

i

A

i

J

iX

(1

i

,A

i

)oi

R

i

J

i

(1

i

,A

i

)oi

=

1

R

i

1

i

J

iK

(1

i

,A

i

)oi

R

i

J

i

(1

i

,A

i

)oi

, due to homogeneity, and hence

n

is small when J

1

is particularly high, that

is, during good times. This also implies that the excess market return is countercyclical, because

market return is positively related to

n

.

In this model, the CAPMfails because there is a systematic factor that the CAPMdoes not price

correctly; that is, the shocks to the price of capital goods. The bottom line is that we can generate

the failure of the CAPM with relative ease compared with the effort involved in generating the

correct cross-sectional distribution of stock returns and book-to-market values simultaneously.

References

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The American Economic Review 84(5), pp. 1369-1384.

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options and security returns, Journal of Finance 54, 1153–1607.

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the Cost of Capital, Financial Management 36(2), 5-17.

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69

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Review 94(5), 1249–1275.

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Asset Price Dynamics: Implications for the Cross Section of Returns, Journal of Finance 59(6),

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Choi, Jaewon, 2010, What Drives the Value Premium: The Role of Asset Risk and Leverage,

University of Illinois Working Paper

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Paper.

Cooper, Ilan, 2006, Asset Pricing Implications of Nonconvex Adjustment Costs and Irre-

versibility of Investment, Journal of Finance 61(1), 139–170.

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Journal of Finance 47, 427–465.

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and Bonds, Journal of Financial Economics 33, 3–56.

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Theory and Tests, The Journal of Finance 44(1), 19–40.

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Leverage Puzzles in the Cross Section of Stock Returns, Journal of Financial Economics, forth-

coming.

Gomes, Joao F., and Lukas Schmid, 2010, Levered Returns, Journal of Finance 65(2), 467-494.

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Edition (McGraw-Hill).

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119(3), 899–927.

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Stock Portfolios and Capital Budgets, Review of Economics and Statistics 47(1), 221–245.

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71

Nontechnical Summary

Motivation and Approach

Firms with a high ratio of book value of equity to market value of equity (value rms) earn higher

expected stock returns than rms with a low book-to-market equity ratio (growth rms). How-

ever, conventional wisdom tells us that growth options should be riskier than assets-in-place and

should therefore have higher expected returns than value rms, which derive their value from

assets-in-place. Additionally, Fama and French (1992) have shown that portfolios of stocks with

different book-to-market ratios have similar riskiness as measured by the standard capital asset

pricing model (CAPM) of Sharpe (1964), Lintner (1965), and Black (1972). This phenomenon,

known as the "value premium puzzle," helped the Fama and French model replace the CAPM as

the benchmark in the asset pricing literature.

This paper presents a dynamic model of the rm with risk-free debt contracts, investment irre-

versibility, and debt restructuring costs, in order to analyze the effects of nancial leverage on in-

vestment and to explain the cross-sectional differences in equity returns. Investment irreversibility

is modeled as in Abel and Eberly (1996), i.e., the resale value of capital is less than the purchase

price of capital. The nancing decisions are similar to those in Fischer, Heinkel, and Zechner

(1989) and Gomes and Schmid (2010), who add capital restructuring costs to the standard tradeoff

theory of capital structure, whereby a rm chooses its nancing policy by balancing the costs of

bankruptcy against the benets of debt, such as tax shields due to interest payments. The model

developed in this paper assumes that rms benet from the tax shield of debt, as in the tradeoff

72

theory, and that they face additional costs at the time of debt restructuring. However, in this paper

debt has two properties distinct from its properties in previous papers: it is risk free and endoge-

nously limited by the lenders to a certain fraction of capital to ensure that the rm honors its debt

payment.

The paper then calibrates the model, drawing on data from the literature and estimating the

remaining parameters using maximum likelihood, based on the long-run stationary distribution

of book-to-market values from the Compustat database. The model captures several facts in the

corporate nance and asset pricing literature in a parsimonious and tractable way and provides

testable implications.

Main Results

1. An important property of the model is that book leverage, that is, the fraction of total capital

supplied by lenders, is state independent. Book leverage is endogenously determined in a manner

that ensures that the rm's value is non-negative even in the worst-case scenario so that the rm

avoids bankruptcy and debt remains risk-free. This worst-case scenario is independent of the state

variables, and hence a revision of the debt agreement at a later date would lead to the same level

of leverage. Thus, it is not optimal for a rm to change its book leverage once it is set. As a result,

book leverage remains the same across rms with different book-to-market equity ratios, whereas

market leverage differs signicantly. This nding is supported by the data. Moreover, because the

level of debt is constant when the rm does not invest, the rm's market debt-to-equity ratio varies

closely with uctuations in its own stock price. This implication of the model is in line with the

73

results of Welch (2004), who nds that U.S. corporations do little to counteract the inuence of

stock price changes on their capital structures.

2. The paper also compares the debt capacity implied by the debt agreement that induces the

no-bankruptcy condition with the standard collateralized debt agreement that limits debt to the

resale value of capital and nds that the former allows greater debt capacity than the latter and

hence is preferred by the rm.

3. The paper shows that investment irreversibility without leverage causes a growth premium

rather than a value premium, i.e., it causes a negative value premium. The rm's investment

opportunity is a call option, because the rm has the right, but not the obligation, to buy a unit of

capital at a predetermined price. As is known from the nancial options literature, when the price

of the underlying security rises and falls, the price of the call option rises and falls at a greater

rate. This suggests that the value of a growth option, that is, the call option to invest, should be

more responsive to economic shocks than the assets-in-place. Therefore, growth options increase

the riskiness of the rm. Similarly, the disinvestment opportunity is a put option, because the rm

has the right, but not the obligation, to sell a unit of capital at a predetermined price. The value

of this put option is negatively related to the value of the underlying asset, because the gain from

exercising it is higher for less productive rms. Therefore, the disinvestment option provides the

value rms that have low productivity with insurance against downside risk and hence reduces

their riskiness. This proposition is different from the recent literature, for example, Zhang (2005)

and Cooper (2006), which presents investment irreversibility as the source of the value premium.

4. The paper nds that nancial leverage affects stock returns directly, through its effect on

74

equity risk, as in Modigliani and Miller (1958), and indirectly, through its effect on business risk,

by inuencing investment decisions. These two channels have opposing effects on the relationship

between book-to-market ratios and stock returns: The Modigliani and Miller channel increases

the equity risk and stock returns of value rms because they have higher market leverage. The

business risk channel increases the effective degree of irreversibility faced by the shareholders and

hence decreases the value premium. However, the Modigliani-Miller effect strongly dominates

the investment channel and explains the major share of the value premium. The paper also pro-

vides empirical analysis consistent with the claim that market leverage is the main source of value

premium.

5. The model is calibrated using maximum likelihood estimation and the long-run distribution

of book-to-market values from the Compustat database. The model is then simulated using the

calibrated values in order to calculate the stock returns and market leverage implied by the model.

The simulation results show that the model ts the data well.

6. Although nancial leverage can explain the major share of the value premium, while in-

vestment irreversibility alone generates instead a growth premium, investment irreversibility still

contributes importantly to improving the model's t with the data, by generating a wide range of

book-to-market values.

7. The model provides two new testable implications: Because nancial leverage increases

effective investment irreversibility through the interest tax-shield, rms with a greater interest tax-

shield invest as if they faced greater investment irreversibility. Moreover, the relationship between

investment irreversibility and stock returns in the model suggests that industries with a higher

75

degree of investment irreversibility, after taking leverage and the interest tax shield into account,

should have a weaker relationship between book-to-market and stock returns.

To summarize, this paper makes a number of contributions to the growing literature that tries

to link corporate decisions to asset returns. First, the debt capacity of the rm is endogenously

determined. Second, the closed-form solution of the model identies explicitly how investment

irreversibility, nancial leverage, and their interaction affect the cross-section of stock returns.

Third, the paper provides a novel calibration exercise that ts the model to the distribution of

book-to-market values, and the calibrated model captures the distribution of book leverage, market

leverage, and stock returns reasonably well. Fourth, the paper provides both theoretical and em-

pirical analysis consistent with the claim that market leverage can explain the major portion of the

value premium. Finally, the model also provides two new testable implications.

76

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