Leverage, Financial Distress and the Cross Section of Stock Returns by Thomas George and Chuan-Yang Hwang Discussant: Ji-Chai Lin Louisiana State University 2006 NTU Conference on Finance, Taipei

Key Findings  Average stock returns are negatively related to book leverage.  Financial distress risk puzzle disappears when leverage is accounted for.  The leverage effect shows up after  Adding a leverage factor to the Fama- French three-factor model helps explain time-series variation in portfolio returns.

Authors’ Interpretation  Firms optimize over financial distress costs in choosing leverage levels.  It implies that firms with low (high) leverage tend to be those for which financial distress is most (least) costly.  Therefore, leverage levels would capture firms’ sensitivities to financial distress risk, and returns will be negatively related to leverage.

General Comments  The results are interesting. But, the interpretation is questionable.  Studies have shown that financial distress costs increase with leverage. –See, e.g., Altman (1984, JF) and Opler and Titman (1998, JF).  The negative relation between stock returns and leverage could be due to other factors. –Garlappi, Shu, and Yan (2006, ROFS, forthcoming) show that the relationship between default probability and equity return tends to be  (i) upward sloping for firms where shareholders are not likely to extract significant benefits from renegotiation (low shareholder advantage) and  (ii) humped and downward sloping for firms where shareholders advantage is strong. –Fama and French (2006, JFE) suggest that, controlling for B/M, lower expected net cash flows imply lower expected stock returns. Firms with higher leverage tend to be less profitable and have lower expected net cash flows, and, thus, could lead to lower expected stock return.

Other Comments  Firms with high leverage tend to have high B/M. –The negative correlation between the leverage factor and the HML is largely due to the way the leverage factor is created (i.e.,low leverage - high leverage).  Ex ante, firms that are not financially constrained might choose to use more debt and have high leverage. –However, ex post, firms with high leverage are likely to be financially constrained.  Also, high leverage firms would be less likely to survive in financial distress than low leverage firms.

Some Issues  Does it make sense to argue that low leverage firms have higher financial distress risk?  Which leverage measure, book leverage or market leverage, is more relevant to measure distress risk?  Why is the leverage effect significant only after 1980, and not before?  Does the leverage effect exist in small firms as well as in large firms?

Final Comment  Overall, I enjoy reading this paper.  I hope my comments are useful.  And, I wish you the best.