Financial Leverage and Expected Stock Returns
This paper examines the cross-sectional relation between leverage and future stock returns. Prior research documents a puzzling negative correlation. We show that it is largely caused by firms’ use of internal financing when information asymmetry between insiders and outsiders is high. Firms with high cost of external equity financing thus can have low leverage, creating a negative correlation between leverage and stock returns. In particular, firms with negative net debt contribute significantly to this phenomenon. We show that a D-measure, constructed from firm fundamentals, provides an effective control for this relationship in cross-sectional stock return tests.