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, G33

Abstract The surge in public debt triggered by the financial crisis has raised uncertainty about future tax pressure and economic activity. We contribute to the current fiscal debate by examining the asset pricing effects of fiscal policies in a production-based general equilibrium model in which taxation affects corporate decisions by: i) distorting profits and investment; ii) reducing the cost of debt through a tax shield; and iii) weakening productivity growth. In settings with recursive preferences, these three tax-based channels generate sizable risk premia making tax uncertainty a first order concern. We document further that corporate tax smoothing significantly affects the cost of equity by altering the intertemporal distribution of consumption. While common tax smoothing increases the annual cost of equity by almost 1%, public financing policies aimed at stabilizing capital accumulation reduce both long-run consumption risk and the cost of capital, producing relevant welfare benefits.

This paper presents a dynamic model of the …rm with risk-free debt contracts and capital and debt adjustment costs. The model …ts several stylized facts of corporate …nance and asset pricing: First, book leverage is constant across di¤erent book-to-market portfolios whereas market leverage di¤ers signi…cantly. Second, changes in the market leverage are mainly caused by changes in stock prices rather than changes in debt. Third, when the model is calibrated to …t the cross-sectional distribution of book-to-market ratios it explains the return di¤erences across di¤erent …rms. The model also shows that investment irreversibility alone cannot generate the cross-sectional patterns in stock returns, which opposes the wisdom in the recent literature. 1

A standard assumption of structural models of default is that firms assets evolve exogenously. In this paper, we document the importance of accounting for investment options in models of credit risk. In the presence of financing and investment frictions, firm-level variables which proxy for asset composition carry explanatory power for credit spreads beyond leverage. As a result, cross-sectional studies of credit spreads that fail to control for the interdependence of leverage and investment decisions are unlikely to be very informative. Such frictions also give rise to a realistic term structure of credit spreads in a production economy.

In this paper I develop and empirically test a model that highlights how the correlation between cash flows and a source of aggregate risk affects a firm’s optimal cash holding policy. In the model, riskier firms (i.e., firms with a higher correlation between cash flows and the aggregate shock) are more likely to use costly external funding to finance their growth option exercises and have higher optimal savings. This precautionary savings motive implies a positive relation between expected equity returns and cash holdings. In addition, this positive relation is stronger for firms with less valuable growth options. Using a data set of US pubic companies, I find evidence consistent with the model’s predictions.

We show that the prospect of a debt renegotiation favorable to shareholders reduces the firm’s equity risk. Equity beta and return volatility are lower in countries where the bankruptcy code favors debt renegotiations and for firms with more shareholder bargaining power relative to debt holders. These relations weaken as the country’s insolvency procedure favors liquidations over renegotiations. In the limit, when debt contracts cannot be renegotiated, equity risk is independent of shareholders ’ incen-tives to default strategically. We argue that these findings support the hypothesis that the threat of strategic default can reduce the firm’s equity risk. WHEN A FIRM IS IN FINANCIAL DISTRESS, its shareholders and debt holders may benefit from a debt renegotiation to avoid an inefficient bankruptcy or liquida-tion. The prospect of a debt reduction through renegotiation may, however, in-duce shareholders to default even if the firm is solvent (Hart andMoore (1994)). The view that shareholders may default for strategic rather than for solvency reasons has proved useful to understand, among other things, the theoretical determinants of corporate bond spreads (Anderson and Sundaresan (1996)), dividend policies (Fan and Sundaresan (2000)), optimal debt structure (Berglöf

This paper evaluates quantitatively the implications of the preferential tax treatment of debt in the United States corporate income tax code. Specifically we examine the economic consequences of allowing firms to deduct interest expenses from their tax liabilities on financial variables such as leverage, default decisions and credit spreads. Moreover our general equilibrium framework allows us to also investigate the consequences of this policy for economy-wide quantities such as investment and consumption. Contrary to conventional wisdom we find that changes in tax policy have only a small effect on equilibrium levels of corporate leverage. The intuition lies in the endogenous adjustment of debt prices in equilibrium that make debt relatively more attractive and largely offset the effect of the changes tax policy.

Recent empirical work using panel data documents that, while the correlation of investment and Tobin’s Q is low, the correlation of investment and credit spreads is high. We propose an explanation for these empirical findings, based on time-varying risk, i.e. stochastic volatility. In our model, firms finance investments using defaultable debt as well as equity issuance, and they are subject to standard profitability shocks as well as shocks to volatility. An increase in volatility leads to an increase in the probability of default and hence the credit spread, while reducing investment and increasing equity value. This shock hence generates a negative correlation between investment and credit spreads, and between investment and Q, helping the model match the data.

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We test whether the …rms systematic equity risk reects the shareholders incentives to default strategically on the …rms debt. We use a real options model to relate the shareholders strategic default behavior to frictions in the debt renegotiation procedure. We test the models predictions with an international cross-section of stocks, exploiting the exogenous cross-country variation of bankruptcy procedures. We …nd that the equity beta increases as debt is more strictly enforced. Moreover, the equity beta decreases with liquidation costs and shareholders bargaining power, and the sensitivity of this relation weakens as the countrys debt renegotiation procedures become more creditor friendly.