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Financial Inflexibility and the Value Premium

Authors


Robert Faff

UQ Business School

University of Queensland

St Lucia

Qld 4072

Australia

r.faff@business.uq.edu.au

Abstract

This paper tests whether and to what extent the value premium is induced by financial inflexibility. In this context, financial flexibility refers to the ability of a firm to alter investment expenditure to mitigate exogenous shocks, so as to generate a smooth dividend stream. Consistent with a literature that identifies three related sources of inflexibility, we create a composite inflexibility index, based on the proportion of fixed assets and measures of total leverage and financial constraints. A positive relation is documented between inflexibility and the book-to-market ratio, and between the returns of inflexible firms and value firms. However, the value premium retains explanatory power independent of inflexibility, suggesting that it is not a proxy for inflexibility alone.

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