Financial Constraints, Debt Capacity, and the Cross-section of Stock Returns




    Search for more papers by this author
    • Hahn is with Yonsei School of Business, Yonsei University. Lee is with College of Economics and Finance, Hanyang University. We thank Heitor Almeida, Murillo Campello, Lauren Cohen (FMA discussant), Pete Frost, Alan Hess, Avi Kamara, Jon Karpoff, Leonardo Madureira (EFA discussant), Paul Malatesta, Ed Rice, Andy Siegel, Stephan Siegel, Deon Strickland (WFA discussant), and seminar participants at the University of Washington, Hanyang University, Yonsei University, Sungkyunkwan University, Seoul National University, and the 2005 WFA, EFA, and FMA meetings for helpful comments and suggestions, and Xi Han for excellent research assistance. We are also grateful to an anonymous referee and the editor Rob Stambaugh for many insightful comments and detailed suggestions. Part of this research was conducted while Hahn was with the University of Washington, Seattle, and Lee with Korea Development Institute.


Building on a model of corporate investment under collateral constraints, we develop and test a hypothesis on the differential effect of debt capacity on stock returns across financially constrained and unconstrained firms. Consistent with the hypothesis, we find that debt capacity is a significant determinant of stock returns only in the cross-section of financially constrained firms, after controlling for beta, size, book-to-market, leverage, and momentum. The findings suggest that cross-sectional differences in corporate investment behavior arising from financial constraints, predicted by theories of imperfect capital markets and supported by empirical evidence, are reflected in the stock returns of manufacturing firms.