Download or read book Capital Structure Dynamics and Stock Returns written by Jie Cai and published by . This book was released on 2013 with total page 37 pages. Available in PDF, EPUB and Kindle. Book excerpt: Many finance theories predict that the capital structure affects firm value, which implies that the changes in leverage have an impact on stock returns. Most of the existing literature however has been focusing on the determinants of the capital structure. Using a sample of U.S. public firms during 1975-2002, we document a significantly negative effect of leverage changes on next-quarter stock returns. This effect remains significant after controlling for other firm characteristics such as ROE, book-to-market, firm size, and past returns. We propose and test several hypotheses to explain the observed effect. We find that the negative effect is stronger for the firms with a higher leverage level. This is consistent with a dynamic view of the pecking-order model that an increase in leverage reduces firms' debt capacity and may lead to future underinvestment. Further tests confirm the negative effect of current leverage change on future investment. In contrast, our results cannot be explained by the trade-off theory, default premium, the market timing theory, or the operational signaling story. Specifically, we find that deviation from the target leverage ratio has no impact on the stock returns, inconsistent with the trade-off theory (which implies an optimal, or partially optimal, leverage ratio). In addition, the change of long-term debt affects stock returns more than the change of short-term debt, and the one-year expected return following leverage change does not increase, both of which are inconsistent with the default risk premium hypothesis. Our results are not driven by firms' market timing activities. A firm times the market by issuing new equity (repurchasing stocks) when its equity is over- (under-) valued, which implies a positive relation between the leverage change and stock return. We also do not find support for the view that leverage increase signals poor future operating performance. Finally, we show that the return effect of leverage change contains information that cannot be explained by the popular pricing factors. This sheds new light on the link between capital structure choice and empirical asset pricing.