Financial leverage, corporate investment and stock returns

This paper presents a dynamic model of the firm with limited capital irreversibility and incomplete debt contracts in order to analyze the effects of financial leverage on investment and explain the cross-sectional differences in equity returns.The model fits several empirical facts of corporate finance and asset pricing: Book leverage is constant across different book-to-market portfolios whereas market leverage differs significantly. Changes in the market leverage ratio are mainly caused by changes in stock prices rather than changes in debt. When the model is calibrated to fit the cross-sectional distribution of book-to-market values it explains the return differences between firms with different book-to-market ratios. The paper also discusses other testable predictions implied by the model such as the cyclicality of value premium and the choice of risk-free versus risky debt.