The Net Benefits to Leverage



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    • Arthur Korteweg is from the Graduate School of Business, Stanford University. This paper is based on my dissertation entitled “The Costs of Financial Distress across Industries,” completed at the University of Chicago. I thank my committee—Monika Piazzesi, Nick Polson, Morten Sørensen, and Pietro Veronesi—for their guidance and support. This paper has benefited greatly from suggestions by an anonymous referee, an associate editor, and Editor Campbell Harvey. I also thank Mike Barclay, Alan Bester, Hui Chen, Peter DeMarzo, John Heaton, Dirk Jenter, Anil Kashyap, Paul Pfleiderer, Michael Roberts, Jay Shanken, Robert Stambaugh, Ilya Strebulaev, Amir Sufi, Michael Weisbach, Jeff Zwiebel, and seminar participants at Boston College, Emory, the University of Chicago, Georgia, London Business School, Notre Dame, Rochester, Stanford, Wharton, and the Board of Governors of the Federal Reserve for helpful discussions, comments, and suggestions. All errors remain my own.


I estimate the market's valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company's debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. I also look at implications for financial policy.