Financial distress and the cross section of equity returns,”

Abstract In this paper, we provide a new perspective for understanding cross-sectional properties of equity returns. We explicitly introduce financial leverage in a simple equity valuation model and consider the likelihood of a firm defaulting on its debt obligations as well as potential deviations from the absolute priority rule (APR) upon the resolution of financial distress. We show that financial leverage amplifies the magnitude of the book-to-market effect and hence provide an explanation for the empirical evidence that value premia are larger among firms with a higher likelihood of financial distress. By further allowing for APR violations, our model generates two novel predictions about the cross section of equity returns: (i) the value premium (computed as the difference between expected returns on mature and growth firms), is humpshaped with respect to default probability, and (ii) firms with a higher likelihood of deviation from the APR upon financial distress generate stronger momentum profits. Both predictions are confirmed in our empirical tests. These results emphasize the unique role of financial distressand the nonlinear relationship between equity risk and firm characteristics-in understanding cross-sectional properties of equity returns. JEL Classification Codes: G12, G14, G3

Investment frictions and leverage dynamics

The paper examines the effect of investment frictions on leverage dynamics, using a model of a firm whose investment projects are (1) indivisible and lumpy, and (2) subject to time-to-build. Regressions on the model-simulated data demonstrate that investment frictions can provide alternative interpretations of the observed leverages shown in the empirical literature. Cross-sectional analysis of firms in the oil and gas extraction industries, as well as analysis across all industries, reveals the evidence that small firms have more volatile investments and longer time-to-build, which may explain the observed differences in leverage dynamics across small and large firms.Dynamic capital structure Time-to-build Lumpy investments Market timing

A Dynamic Model of Optimal Capital Structure

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. In the model we endogenize the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore cross-sectional as well as time-series variation in debt ratios. We pay particular attention to interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the debt ratio affects the deviation of actual debt ratios from their targets. Regressions estimated on simulated data generated by our model are roughly consistent with actual regressions estimated in the empirical literature. Copyright 2007, Oxford University Press.

Originator Performance, CMBS Structures, and the Risk of Commercial Mortgages

This article examines information and incentive problems that can exist in the market for commercial mortgages that are pooled and repackaged as commercial mortgage-backed securities (CMBSs). We find that mortgages that are originated by institutions with large negative stock returns in the quarters prior to the origination date tend to have higher credit spreads and default more than other mortgages with similar observable characteristics. Properties financed with these mortgages also exhibit weaker post-securitization operating performance. In addition, stock price loser institutions are anxious to securitize mortgages they originate more quickly. Finally we find that credit rating agencies require higher levels of subordination for CMBS pools (i.e., view these pools as riskier) that include more mortgages originated by underperforming originators. This evidence is consistent with reputation models in which poorly performing originators have less incentive to carefully evaluate the credit quality of prospective borrowers, thereby letting relatively riskier mortgages pass through their weaker screening standards. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

A Dynamic Model of Optimal Capital Structure

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. The model extends the existing literature by endogenizing the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the capital structure choice affects debt choices. The model simultaneously generates quantitative implications on how firm characteristics such as the depreciation rate of the firm's assets, expected future growth opportunities, financial distress costs, taxes and transaction costs affect choice of debt ratiosCapital Structure Choice, Investment Decisions, Transaction Costs, Agency Problems