Implied Penalties for Financial Leverage: Theory versus Empirical Evidence

By Marston, Felicia; Perry, Susan | Quarterly Journal of Business and Economics, Spring 1996 | Go to article overview

Implied Penalties for Financial Leverage: Theory versus Empirical Evidence


Marston, Felicia, Perry, Susan, Quarterly Journal of Business and Economics


INTRODUCTION

This study takes a new look at an old issue - the relationship between financial leverage and beta and, hence, between financial leverage and required return. Our motivation for returning to this question is based on three concerns: the conflicting results in extant empirical work, the recent controversy in the validity of beta as a discriminating measure of security risk (Fama and French, 1992), and the use of Hamada (1972) and similar techniques for unlevering and relevering betas for purposes of estimation of the cost of equity.

The theoretical literature dictates a positive and linear relationship between required return and leverage, as formulated by Modigliani and Miller (1858, 1963) within a constant risk class framework. Modigliani and Miller show, on both a no tax and after corporate tax basis, that the required return on equity of a levered firm increases in proportion to the debt-to-equity ratio. Hamada (1969, 1972) rederives the Modigliani and Miller propositions within a portfolio theoretic framework and shows that parallel relationships hold between equity betas and leverage as well. The major implication of the above works is that frans with the same asset risk but different degrees of leverage should have different costs of equity, with the market requiring higher returns on the more highly levered firm.

Opposing such paradigms is the traditionalist view. The traditionalists maintain that the market does not require higher returns for more highly levered frans until some critical leverage point is reached. At that point, required return will increase more dramatically with increases in financial leverage than that suggested by the later models of Modigliani and Miller and Hamada. Thus, within this framework, the cost of equity for frans within a given risk class will be constant across firms as long as critical leverage is not reached. [For one discussion of the traditionalist position, see Barges (1963).] While the arguments for the traditionalist position lack strong theoretical support (Brealey and Myers, 1988, pp. 396-397), the position nonetheless may reflect the perceptions of investors and analysts and the workings of financial markets. Surprisingly, while there has been a plethora of empirical research relating beta to financial leverage and a host of other variables, little research has tested how closely the actual Hamada relationships hold or has tested the Hamada relationship vis-a-vis the traditional position.

This article examines this issue from several perspectives. First, using ordinary least squares regression, we consider the Hamada proposition of a linear relationship between beta and financial leverage. Consistent with other studies, we find inconclusive results using this fairly simple test. We then relax the linearity assumption, and we use switching regime regressions to test for the nonconstant relationship between leverage and required return posited by traditionalist theories. Again, we find inconsistencies in the results of the switching regime models. Given the inconsistent results in tests of both the Hamada and the traditionalist models, we attempt to disentangle these mixed results by constructing a carefully controlled matched pair sample.

Examination of this issue is important for several reasons. Most managerial finance texts emphasize that a firm's equity risk arises from two components - operating risk and financial risk - and that market measures of equity risk, such as beta, should be delevered (typically with the Hamada adjustment) from the effects of financial risk in order to determine the asset risk premium applicable to the average firm project. To the extent that the Hamada adjustment for leverage fails to hold in practice, asset betas will be biased, leading to incorrect divisional costs of capital and capital budgeting decisions. Additionally, in the event the traditionalists are correct, firms that strive for a target beta would want to monitor more closely changes in operating risk over changes in financial risk. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Implied Penalties for Financial Leverage: Theory versus Empirical Evidence
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.