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Journal of Finance Vol. 66 No. 3 2011

Financial Distress and the Cross‐section of Equity Returns

Lorenzo Garlappi1; Hong Yan2,3,4,5,6,7

1 The University of Texas at Austin · 2 Texas Tech University · 3 University of South Carolina · 4 City University of Hong Kong · 5 Chinese University of Hong Kong · 6 Institute of Natural Science · 7 University of Hong Kong

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.

DOI
10.1111/j.1540-6261.2011.01652.x
Volume
66
Issue
3
Pages
789-822
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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