Abstract
This paper tests the degree to which a sustainable relationship exists between financial leverage and the systematic risk of shareholders under the following capital market imperfections: corporate and personal taxes as well as risky debt and bankruptcy costs. This beta-leverage relationship has not yet been examined empirically in prior studies nor compared with the theoretical parameter values implied by well-known formulations in the literature. Using data from publicly traded American industrial firms, we found that risky debt models, rather than their corresponding risk free debt models, are more sustainable and appropriate for describing the link between equity beta and financial leverage. Our findings imply that estimating betas or unlevering betas based on risk free debt models might lead to unsustainable and inaccurate estimates of key corporate parameters such as the cost of capital, and may consequently lead to inappropriate capital budgeting decisions. In this respect, the results of this study might have consequences to the recently growing area of sustainable finance in the sense that investment decisions made by different bodies and institutions in the country are more consistent with market imperfections that exist in the economy. In other words, our findings can be in line with a sustainable financial marketplace that contributes to the economic efficiency in the long run and can be related to social well-being.
Highlights
One of the forces underlying the recent global financial crisis is the impact of debt on asset values, which can be related to the concept of sustainable investment and the selection and management of investments
The motivation of this paper is to extend the empirical tests of the beta-leverage relationship in the literature by examining whether frictions such as default risk, corporate and personal taxes, and bankruptcy costs have an impact on the relationship between beta and financial leverage, and to realize whether risk free debt or risky debt theoretical models are a better reflection of the real relationship between beta and leverage
We used a number of different estimates for the variables including financial leverage, corporate tax rate, personal tax rate, debt beta, and bankruptcy costs, yielding numerous results from the regression equations
Summary
One of the forces underlying the recent global financial crisis is the impact of debt on asset values, which can be related to the concept of sustainable investment and the selection and management of investments. MM’s [1,2] theoretical model dictates a positive and linear relationship between the cost of equity capital and financial leverage within the same business risk class This theoretical foundation was later extended in the pioneering works of Hamada [3,4] and Rubinstein [5], who formulated a theoretical relationship between equity betas and leverage. Their discussions were only confined to the simple case of risk free debt and corporate taxes. Conine [6] extended Hamada and Rubinstein’s theoretical formulations to the case of risky debt, while Yagil [7] expanded the theoretical formulations to the general case of both corporate and personal taxes as well as risky debt and bankruptcy costs
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