Financially Constrained Stock Returns





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    • Dmitry Livdan is from the Walter A. Haas School of Business, University of California, Berkeley. Horacio Sapriza is from Rutgers Business School and the Federal Reserve Board. Lu Zhang is from the Stephen M. Ross School of Business, University of Michigan and NBER. We acknowledge helpful comments from Sreedhar Bharath, João Gomes, Leonid Kogan, Martin Schneider (AFA discussant), Amir Yaron, and seminar participants at the 2005 American Finance Association Annual Meetings in Philadelphia. Rob Stambaugh (the editor) and two anonymous referees deserve special thanks. All remaining errors are our own. An earlier version of the paper was circulated under the title “A neoclassical model of financially constrained stock returns.”


We study the effect of financial constraints on risk and expected returns by extending the investment-based asset pricing framework to incorporate retained earnings, debt, costly equity, and collateral constraints on debt capacity. Quantitative results show that more financially constrained firms are riskier and earn higher expected stock returns than less financially constrained firms. Intuitively, by preventing firms from financing all desired investments, collateral constraints restrict the flexibility of firms in smoothing dividend streams in the face of aggregate shocks. The inflexibility mechanism also gives rise to a convex relation between market leverage and expected stock returns.