Investigating the return predictability of changes in corporate borrowing

Edward Lee, Konstantinos Stathopoulos and Mark Hon

Accounting and Business Research, 2006, vol. 36, issue 2, 93-107

Abstract: This study investigates the return predictability of changes in corporate borrowing by conditioning it on equity styles. state of market, and earnings expectation to determine whether it is due to unidentified sources of risk or mispricing. We observe that increases in borrowing are indeed followed by declines in operating and risk-adjusted return performance. However, the return underperformance exists only in small-cap growth companies experiencing negative earnings surprise, irrespective of the market state. We extend previous studies by demonstrating that the phenomenon is not pervasive over the entire cross-section of the stock market and is likely to be a manifestation of negative price response against the earnings disappointment of small-cap growth companies. Our results have implications for market efficiency and stock selection.

Date: 2006
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DOI: 10.1080/00014788.2006.9730012

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