Taxes, Leverage, and the Cost of Equity Capital

We examine the associations among leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958, 1963] , the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. Based on this expression, we predict that the cost of equity is increasing in leverage, and that corporate taxes mitigate this leverage‐related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium from leverage is increasing in the personal tax penalty associated with debt.     

The cost of capital and optimal financing policy in a dynamic setting

This paper revisits the Modigliani–Miller propositions on the optimal financing policy and cost of capital in a dynamic setting. In an environment without taxes and bankruptcy costs, the results are generally consistent with the Modigliani–Miller Propositions 1 and 2. However, the first proposition should be presented and interpreted more carefully, as given firm characteristics, there is only one optimal capital structure. Thus, a firm’s capital structure is relevant. A relaxation of assumptions about either taxes or bankruptcy costs leads to conclusions that are generally different from those in Modigliani and Miller (1958). The model predicts that leverage and sales-to-capital ratios decrease but firm size and capital stock increase with the subjective discount factor of the firm’s manager if there are taxes and bankruptcy costs. The empirical analysis supports these predictions.     

New Evidence on Sources of Leverage Effects in Individual Stocks

I test Black's leverage effect hypothesis on a panel of U.S. stocks from 1997 to 2012. I find that negative stock return innovations increase the future volatility of equity returns by about 36% more than positive ones. There is a strong and positive relation between variation in the size of these leverage effects and variation in the firm's use of debt. I uncover this relation by applying the Fama/French/Carhart 4‐factor asset pricing model in the exponential generalized autoregressive conditional heteroskedasticity mean equation and by using panel data to control for firm‐ and time‐invariant unobservables via first differences and two‐way fixed effects.     

Equilibrium "Anomalies"

Many empirical “anomalies” are actually consistent with the single beta capital asset pricing model if the empiricist utilizes an equity‐only proxy for the true market portfolio. Equity betas estimated against this particular inefficient proxy will be understated, with the error increasing with the firm's leverage. Thus, firm‐specific variables that correlate with leverage (such as book‐to‐market and size) will appear to explain returns after controlling for proxy beta simply because they capture the missing beta risk. Loadings on portfolios formed on relative leverage and relative distress completely subsume the powers of the Fama and French (1993) returns to small minus big market capitalization (SMB) portfolios and returns to high minus low book‐to‐market (HML) portfolios factors in explaining cross‐sectional returns.     

Anomalies and stock returns: Australian evidence

Prior research has identified the existence of several cross‐sectional patterns in equity returns, commonly referred to as effects. This paper tests for the existence of a number of well‐known effects using data from the Australian equities market. Specifically, we investigate the size effect, book‐to‐market effect, earnings‐to‐price effect, cashflow‐to‐price effect, leverage effect and the liquidity effect. An additional aim of this paper is to investigate the capability of the Fama–French model in explaining any observed effects. We document a size, book‐to‐market, earnings‐to‐price and cashflow‐to‐price effect but fail to find evidence of a leverage or liquidity effect. Although our findings indicate that the Fama–French model can partially explain some of the observed effects, we conclude that its performance is less than satisfactory in Australia.     

Estimating the Cost of Equity Capital for Property-Liability Insurers

This article presents new evidence on the cost of equity capital by line of insurance for the property‐liability insurance industry. To do so we obtain firm beta estimates and then use the full‐information industry beta (FIB) methodology to decompose the cost of capital by line. We obtain full‐information beta estimates using the standard one‐factor capital asset pricing model and extend the FIB methodology to incorporate the Fama–French three‐factor cost of capital model. The analysis suggests the cost of capital for insurers using the Fama–French model is significantly higher than the estimates based upon the CAPM. In addition, we find evidence of significant differences in the cost of equity capital across lines.     

A Look Back at Modern Finance: Accomplishments and Limitations

In a conversation held in June 2016 between Nobel laureate Eugene Fama of the University of Chicago and Joel Stern, chairman and CEO of Stern Value Management, Professor Fama revisited some of the landmarks of “modern finance,” a movement that was launched in the early 1960s at Chicago and other leading business schools, and that gave rise to Efficient Markets Theory, the Modigliani‐Miller “irrelevance” propositions, and the Capital Asset Pricing Model. These concepts and models are still taught at prestigious business schools, whose graduates continue to make use of them in corporations and investment firms throughout the world. But while acknowledging the staying power of “modern finance,” Fama also notes that, even after a half‐century of research and refinements, most asset‐pricing models have failed empirically. Estimating something as apparently simple as the cost of capital remains fraught with difficulty. He dismisses betas for individual stocks as “garbage,” and even industry betas are said to be unstable, “too dynamic through time.” What's more, the wide range of estimates for the market risk premium—anywhere from 2% to 10%—casts doubt on their reliability and practical usefulness. And as if to reaffirm the fundamental insight of the M&M “irrelevance” propositions—namely, that what companies do with the right‐hand sides of their balance sheets “doesn't matter”—Fama observes that “we still have no real resolution on the key questions of debt and taxes, or dividends and taxes.” But if he has reservations about much of modern finance, Professor Fama is even more skeptical about subfields now in vogue such as behavioral finance, which he describes as “mostly just dredging for anomalies,” with no underlying theory and no testable predictions. Although he does not dispute that a number of well‐documented traits from cognitive psychology show up in individual behavior, Fama says that behavioral economists have thus far failed to come up with a testable theory that links cognitive psychology to market prices. And he continues to defend the concept of “efficient markets” with which his name has long been closely associated, while noting that empirically based asset pricing models such as his (with Ken French) “three‐factor” CAPM have produced much better results than the standard CAPM.     

A Dynamic Model of Firm Valuation

We propose a dynamic version of the dividend discount model, solve it in closed form, and assess its empirical validity. The valuation method is tractable and can be easily implemented. We find that our model produces equity value forecasts that are very close to market prices, and explains a large proportion of the observed variation in share prices. Moreover, we show that a simple portfolio strategy based on the difference between market and estimated values earns considerably positive returns. These returns cannot be simply explained either by the Fama‐French three‐factor model (even after adding a momentum factor) or the Fama‐French five‐factor model.     

Do the Fama–French Factors Proxy for Innovations in Predictive Variables?

The Fama–French factors HML and SMB are correlated with innovations in variables that describe investment opportunities. A model that includes shocks to the aggregate dividend yield and term spread, default spread, and one‐month Treasury‐bill yield explains the cross section of average returns better than the Fama–French model. When loadings on the innovations in the predictive variables are present in the model, loadings on HML and SMB lose their explanatory power for the cross section of returns. The results are consistent with an ICAPM explanation for the empirical success of the Fama–French portfolios.     

Payout Policy Relevance and Accounting‐based Valuation

DeAngelo and DeAngelo (2006) (D&D) argue ‘payout policy is not irrelevant and investment is not the sole determinant of value, even in frictionless markets’. Consistent with this view, we argue that the concept of a perfect capital market in Miller and Modigliani (1961) (M&M) and Fama and Miller (1972) can be extended to allow for managerial moral hazard if managers are assumed not to participate in securities trading. An updated version of the M&M valuation model is presented and the possibility of managerial free cash flow (FCF) retention through operating expense manipulation and sub‐optimal investment policies is discussed. Our analysis supports D&D's argument that payout policy is relevant and indicates that value relevance of payout depends on the quality of earnings measurement and the optimality of investment policy. Following this, we develop a framework for analyzing valuation and informational roles of payout in accounting‐based valuation models and apply this framework to the Ohlson (1995) and Feltham and Ohlson (1996) models. This analysis shows how these models permit payout valuation relevance due to managerial FCF retention but not payout informational relevance. Finally, we consider how the Feltham and Ohlson (1996) model can be extended to incorporate time variation in expected profitability of capital investment caused by time variation in managerial FCF retention activities and show that this explicitly affects payout value relevance. We conclude that the development of models where payout plays an explicit valuation role due to issues of moral hazard is an important direction for future research.     

INTANGIBLE ASSETS,BOOK‐TO‐MARKET,AND COMMON STOCK RETURNS

I examine two anomalies where the Fama and French three‐factor model fails to adequately explain monthly industry and index returns. Both anomalies are consistent with a bad model problem where the book‐to‐market factor introduces a negative bias in the intercepts. I propose the intangibles model as an alternative where the three‐factor model is known to have difficulty. This alternative model, which replaces the book‐to‐market factor with zero investment portfolio returns based on prior investments in intangible assets, is well specified in random samples, has comparable power, and fully explains both anomalies.     

Alternative measures of the Federal Reserve Banks’ cost of equity capital

The Monetary Control Act of 1980 requires the Federal Reserve System to provide payment services to depository institutions through the 12 Federal Reserve Banks at prices that fully reflect the costs a private-sector provider would incur, including a cost of equity capital (COE). Although Fama and French [Fama, E.F., French, K.R., 1997. Industry costs of equity. Journal of Financial Economics 43, 153–193] conclude that COE estimates are “woefully” and “unavoidably” imprecise, the Reserve Banks require such an estimate every year. We examine several COE estimates based on the CAPM model and compare them using econometric and materiality criteria. Our results suggest that the benchmark CAPM model applied to a large peer group of competing firms provides a COE estimate that is not clearly improved upon by using a narrow peer group, introducing additional factors into the model, or taking account of additional firm-level data, such as leverage and line-of-business concentration. Thus, a standard implementation of the benchmark CAPM model provides a reasonable COE estimate, which is needed to impute costs and set prices for the Reserve Banks’ payments business.     

Investor heterogeneity,market segmentation,leverage and the equity premium puzzle

Financial economists for the past two decades have attempted to explain why the equity premium is so high, now known as the equity premium puzzle (EPP). We model investor heterogeneity, market segmentation and optimal leverage, using the time separable standard power utility, market completeness and ignoring transaction costs to explain the EPP. We explain both the EPP and the related risk-free rate puzzle without resorting to preference modification. Furthermore, we show a unique interior equilibrium for the debt ratio, contrary to the work by F. Modigliani, M.H. Miller (The cost of capital, corporation finance and the theory of investment, American Economic Review 48 (1958) 261–297; Corporate income taxes and the cost of capital, American Economic Review 53 (1963), 433–443) and S.C. Myers (Presidential address: The capital structure puzzle, Journal of Finance 39 (1984), 575–592). Our simulations show the relevance of our models.     

The reduced-rank beta in linear stochastic discount factor models

In a linear stochastic discount factor model, failure of the full-rank conditions affects the standard statistical inference of coefficients. We propose a novel risk measurement, the reduced-rank beta, which is the risk sensitivity to the effective part of factors for the full-rank covariance matrix. Our reduced-rank beta is a generalisation of the standard beta when the full-rank condition is not satisfied. By considering the Fama–French five-factor (FF5) model for the US equity market, the failure of the full-rank condition is found to affect beta estimates. We demonstrate the reduced-rank beta has important empirical implications for model reductions and anomaly explanations.     

LIQUIDITY AND ASSET PRICING UNDER THE THREE‐MOMENT CAPM PARADIGM

We examine whether the use of the three‐moment capital asset pricing model can account for liquidity risk. We also make a comparative analysis of a four‐factor model based on Fama–French and Pástor–Stambaugh factors versus a model based solely on stock characteristics. Our findings suggest that neither of the models captures the liquidity premium nor do stock characteristics serve as proxies for liquidity. We also find that sensitivities of stock return to fluctuations in market liquidity do not subsume the effect of characteristic liquidity. Furthermore, our empirical findings are robust to differences in market microstructure or trading protocols between NYSE/AMEX and NASDAQ.     

The UK Equity Premium: 1901–2004

Abstract:  This paper examines the UK equity premium over more than a century using dividend growth to estimate expectations of capital gains employing the approach of Fama and French (2002) . Over recent decades estimated equity premia implied by dividend growth have been much lower than that produced by average stock returns for the UK market as a whole; a finding corroborated by all economic sub-sectors. The empirical analysis suggests this is primarily due to a declining discount rate, during the latter part of the 20th century, which would rationally stimulate unanticipated equity price rises during this period. Thus, I conclude that historical stock returns over recent decades have been above investors' expectations.     

A Test of the Modigliani‐Miller Invariance Theorem and Arbitrage in Experimental Asset Markets

Modigliani and Miller show that the total market value of a firm is unaffected by a repackaging of asset return streams to equity and debt if pricing is arbitrage‐free. We investigate this invariance theorem in experimental asset markets, finding value‐invariance for assets of identical risks when returns are perfectly correlated. However, exploiting price discrepancies has risk when returns have the same expected value but are uncorrelated, in which case the law of one price is violated. Discrepancies shrink in consecutive markets, but persist even with experienced traders. In markets where overall trader acuity is high, assets trade closer to parity.     

TRANSITORY MARKET STATES AND THE JOINT OCCURRENCE OF MOMENTUM AND MEAN REVERSION

In this article we derive and investigate the implications of the Fama–French and Poterba–Summers model—in which the market price of equity contains permanent and temporary components—to explain cross‐sectional differences in equity risk premia and returns. Shocks to the transitory component are regarded a Merton risk factor. We obtain estimates from a simple Kalman decomposition of the market price. The transitory component estimate is used in a conditional capital asset pricing model to test implications of the model related to predictability, cross‐sectional performance, and the existence of momentum and mean reversion.     

TEXTBOOK INCONSISTENCIES IN GRAPHING VALUATION EQUATIONS: A FURTHER NOTE

In this note, the authors demonstrate that if a firm's leverage ratio is measured by debt-to-total value (debt-to-equity) in the pure capital structure rearrangement framework implicit in research reported by Modigliani and Miller (e.g., debt-to-equity exchanges), the market value of levered equity will be a concave (convex) function, and the market value of debt will be a convex (concave) function. These nonlinearities exist even without bankruptcy costs.     

Cross‐sectional Tests of Conditional Asset Pricing Models: Evidence from the German Stock Market

We study the performance of conditional asset pricing models and multifactor models in explaining the German cross‐section of stock returns. We focus on several variables, which (according to previous research) are associated with market expectations on future market excess returns or business cycle conditions. Our results suggest that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved when allowing for time‐varying parameters of the stochastic discount factor. A conditional CAPM using the term spread explains the returns on our size and book‐to‐market sorted portfolios about as well as the Fama‐French three‐factor model and performs best in terms of the Hansen‐Jagannathan distance. Structural break tests do not necessarily indicate parameter instability of conditional model specifications. Another major finding of the paper is that the Fama‐French model – despite its generally good cross‐sectional performance – is subject to model instability. Unconditional models, however, do a better job than conditional ones at capturing time‐series predictability of the test portfolio returns.