Judson Caskey

Leverage, excess leverage, and future returns

We examine the cross-sectional relation between leverage and future returns while considering the dynamic nature of capital structure and potentially delayed market reactions. Prior studies find a negative relation between leverage and returns that contradicts standard finance theory. We decompose leverage into target and excess components and find that excess leverage drives this negative relation. We also find that excess leverage predicts firm fundamentals, and that the negative relation between excess leverage and future returns can be explained by investors’ failure to react promptly to the information in excess leverage about the firm’s probability of distress and future asset growth. Under static asset pricing theories such as the CAPM or the APT, financial leverage has a straight-forward effect on stocks’ expected returns through betas on systematic factors. Controlling for the effects of leverage on factor sensitivities, one should find no relation between leverage and expected returns; controlling only for asset risk, the relation between leverage and expected returns should be positive because debt can magnify exposure to systematic risks. Notwithstanding the simplicity of these predictions, prior empirical studies find the opposite relation. In particular, Penman, Richardson, and Tuna (2007) document a negative association between leverage and future returns, after controlling for conventional risk proxies. A parallel literature on the pricing of distress risk (e.g., Dichev (1998), Griffin and Lemmon (2002), Vassalou and Xing (2004), Campbell, Hilscher, and Szilagyi (2008), Chava and Purnanandam (2009)) also in general finds that distress intensity is negatively related with future returns. The purpose of this study is to examine plausible mechanisms that may explain the puzzling negative relation between leverage and future returns. The novelty of our analysis lies in that we relax the implicit assumption of a fixed capital structure, and that we consider both risk and market mispricing mechanisms. Similar in spirit to Brennan and Schwartz (1984) and Myers (1984), we adopt the view that a firm’s capital structure is dynamic. Specifically, leverage temporarily deviates from its optimum due to random shocks and firms do not immediately resolve the resulting distortion, or excess leverage, because of transactions costs. Under this approach, the target and excess components of leverage have very different economic implications for the firm. One can view target leverage as having long-term effects on returns similar to that specified in static asset pricing models that hold capital structure fixed. Excess leverage has a more complex relation with returns since it reflects a shock to the firm’s long-run debt capacity and/or to actual 1 These two phenomena are related because leverage is positively correlated with financial distress.

Investor Cost Basis and Takeover Bids

This study examines how institutional investors’ cost bases impact takeover offer prices and the likelihood of deal success. We find evidence consistent with the ‘disposition effect’ - a reluctance to realize losses. After controlling for pre-bid prices, cost basis has a positive association with both offer prices and the likelihood of deal acceptance. We find that this behavior is mostly concentrated within short term focused, transient investors. We also use post-bid-rejection returns to provide evidence that the disposition effect, rather than private information, drives the rejection of bids with offer prices that fall short of the average cost basis.