Financial Leverage, Corporate Investment, and Stock Returns

Abstract

This article rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model analytically shows that tax deductibility of interest payments increases effective investment irreversibility and that investment irreversibility weakens the relation between book-to-market values and returns. This provides a clear and novel mechanism showing how financial leverage affects stock returns beyond the standard Modigliani-Miller paradigm. The article argues that market leverage, rather than operating leverage or investment irreversibility, explains a major portion of the value premium. Empirical evidence supports this argument.