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Leverage Change, Debt Capacity, And Stock Prices, Jie Cai, Zhe (Joe) Zhang

Research Collection Lee Kong Chian School Of Business

We document a significantly negative effect of the change in a firm’s leverage ratio on its stock prices. This effect cannot be explained by popular asset pricing factors or firm characteristics. We find that the negative effect is stronger for firms with limited debt capacity. Moreover, firms with an increase in leverage ratio tend to have less future investment, even after controlling for growth option and target leverage. These findings are consistent with a dynamic view of the pecking-order theory that an increase in leverage reduces firms’ safe debt capacity and may lead to future underinvestment, thus reducing firm value. …