Financial Distress and the Cross-section of Equity Returns

Financial Distress and the Cross-section of Equity Returns

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Article ID: iaor201112056
Volume: 66
Issue: 3
Start Page Number: 789
End Page Number: 822
Publication Date: Jun 2011
Journal: The Journal of Finance
Authors: ,
Keywords: stock prices
Abstract:

We explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

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