The value effects of capital structure : essays on leverage and its impact on stock returns</

This thesis examines if leverage can explain stock returns. Due to the overwhelming influence of Modigliani and Miller (1958)'s seminal work on capital structure where they argue that firm value is independent of financing decisions, limited work has been undertaken on leverage as an independent variable or a risk factor in explaining stock returns. On the other hand, theoretical finance has always regarded debt as one of the principle sources of financial risk. An immediate implication of the Modigliani and Miller (1958)'s propositions on equity returns is that they should increase in leverage. This thesis sets out to test the relation between equity returns and stock returns by undertaking a firm level and portfolio level analysis. This thesis comprises four empirical chapters. The first empirical chapter undertakes a firm level analysis. f estimate abnormal returns on leverage portfolios in the time-series for different sectors. I find for most sectors, abnormal returns decline in firm leverage. However, abnormal returns increase as average leverage in a risk class increases. The separation of the average level of external financing in an industry and of that in a particular firm is important. Utilities for which Modigliani and Miller (1958) report their empirical results (i. e. that returns increase in firm leverage) are in fact sectors with high concentrations and firm leverage ratios very close both to one another and to the industry average. In the Utilities risk class, abnormal returns increase in firm leverage. For other sectors, this is not the case and abnormal returns decline in firm leverage and increase in industry leverage. Results are robust with regard to other risk factors. 'This second empirical chapter investigates the effect of a firm's leverage on stock returns based on the explicit valuation model of Modigliani and Miller (1958) testedin the utilities, oil and gas industries. I test the relationship between leverage and stock returns in all risk classes. For utilities, returns increase in leverage. This is consistent with the findings of Modigliani and Miller (1958). For the other risk classes, returns fall in leverage. Results are robust to other risk factors. The third empirical chapter is an empirical study that tests the relationship between leverage and stock returns at the portfolio level. I investigate this relationship by undertaking a portfolio level analysis of leverage and expected returns using the Fama-Macbeth (1973) methodology with modifications. I find that returns increase in leverage which is consistent with the findings of Miller-Modigliani (1958). I also undertake linearity tests. Results are robust to other risk factors. Leverage is an important risk factor which has been ignored in the asset pricing literature. The fourth empirical chapter attempts to broaden the focus of the current asset pricing literature by forming portfolios mimicking the leverage factor. Returns are ranked according to leverage and grouped into two groups of high and low to demonstrate the risk factor of leverage in stocks. I argue that leverage is an important stock-market factor that explains stock returns. I also undertake robustness checks with the Fama-French (1993) factors of size, market-to-book and excess returns on market. My results show that our leverage mimicking portfolio capture the variations in stock returns better relative to the other asset pricing models.