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ABSTRACT
The expected common stock returns are positively related to the ratio of debt (non-
commonequity liabilities)to equity,controllingfor the beta and firm size and including
as well as excluding January, though the relation is much larger in January. This
relationshipis not sensitive to variations in the marketproxy, estimation technique,
etc. The evidencesuggests that the "premium"associatedwith the debt/equity ratio is
not likely to be just some kind of "riskpremium".
Panel
t-Statistic
Estimated Including
t-Statistic
t-Statistic
Excluding Including
t-Statistic
Excluding A:
t-Statistic [E(ri)
=
yo
January
January January
January +
Panel Weighted
Test-Period
C: (in Estimated
Beta
Inverse -y1LTEQi
Summary
+
Estimated Panel
0.07
(0.94) 0.52 1.01B: 0.56 1.01 Coefficients
Constant
Proportion
Simple to Statistics
'Y2BETAi
Test-Period
for+ (Percent
-0.00 (0.01)
(-0.23) -0.11 (-0.45)
0.00(-3.00) -0.01 -0.10 LTEQ
(-3.12)
Betas All-Firms
the per
of Averages Estimated
of
the
0.17the (0.60)
0.01(0.60)
0.93 (0.04) 0.30 BETA
0.16(1.23) Sampley3DERi],
Table
(-1.00) I
Standard Month)
Their
for
Estimated Explanatory
-0.00 (2.47)
(-0.08) 0.13Subperiod
0.09(3.84) (2.37) DER
0.09Errors)
0.05(3.93) the
Mean
Coefficients Estimated
0.18
(2.10) 1.01 1.45 0.85 1.29Averages Variables:
of Constant
Estimates the
(Including
-0.01 -0.02 -0.12 -0.02 -0.11 LTEQ Expected-Return
Test-Period
(-0.47) (-0.57) (-3.32) (-0.62)(-3.14) 1948-1979a
Subperiod
January)
Manufacturing-Firms
Betas,
-0.05Mean
0.83
(-2.39) -0.40
(-1.47) -0.24
(-0.87) -0.19
(-0.76)(-0.21) BETA Equation
Sampleand
0.02 0.11(3.47)
0.18 0.17Estimates
0.10(3.91)
the
(0.82) (2.00) (2.24) DER
case the
of period results
subperiod.
areaLTEQ, Mean
Range:
the DER Median
betas medians BETA
corresponding
approximately Correlation
are and Thebased Minimum
Maximum
BETA,
on with:
coefficient
of ranges
standard
subperiodand
are test-period
distributed Panel
as DER
for
normal values. D:
BETA). betas
twenty-seven
The stand
these
under and for
"Student's"
the valuesthe the Summary
t portfolios,
of
nullaveraged
with
themeans
15 Statistics
formed
values.and logarithm
-0.33
-0.44 2.29
6.10 3.87
3.97for
d.f. by
of
hypothesis
The the
under explanatory total
that ranking
the 0.25 1.440.60 0.980.96
the correlations
the
null t-statistics
of equity,
variables Explanatory
for
arethe
the 4.440.17 0.911.38
coefficient securities
is
hypothesis on debt/equity Variables
averaged at
average the
thatzero. explanatory
ratio, the
thethe
across and
estimated
variables
explanatory Portfolio
test-period are -0.44
-0.47 6.172.16 3.763.94
t-statistics
subperiodsestimated Level
for for
beta variables,
coefficients
is the simplebeta,
areeach for 0.51 1.420.72 1.011.02
zero
each
(one, averages
estimated
in portfolio,
of respectively. 2.810.14 0.690.97
distributed
thetest-
as andthetwo-year
All
3.5
3
o
I 2.5
48-49 50-51 52-53 54-55 56-57 58-59 60-61 62-63 64-65 66-67 68-69 70-71 72-73 74-75 76-77 78-79
Subperiod
Figure 1. Average Debt/Equity Ratio by Subperiods
estimates including January are sixteen percent, fifteen percent, and thirty-five
percent lower for the coefficients of LTEQ,BETA, and DER, respectively,in the
all-firms sample. They are eleven percent, fifteen percent, and twenty percent
lower,respectively,in the manufacturing-firmssample.A largergain in precision
occurs for the coefficient of DER, especially in the all-firms sample, partly due
to the larger variation in the sampling variances of the month-by-month esti-
mates across subperiodsand partlybecause the standarderrorof the SA estimate
is overestimated due to the nonconstancy of this coefficient, both of which in
turn are mostly due to the extreme DERs as discussedbelow.
In the all-firms sample, the SA estimate gives a much higher coefficient for
DER compared with the WA estimate including or excluding January. This
difference indicates significant changes in this coefficient across subperiods,
which in turn can be traced mainly to the extreme DERs discussed above. The
extreme DERs result in smaller estimated coefficients for DER, indicating that
the linear functional form for DER proposedin (1) is probablynot adequatefor
the extreme DERs. They also result in lower estimated standarderrors for the
estimated coefficients of DER because they double, triple, and even quadruple
the dispersion of the DERs. For example, for the subperiod1958-1959, which is
a typical subperiod without many extreme DERs, the mean estimate of the
coefficient of DER includingJanuaryis 0.16 percent, with an estimated standard
errorof 0.14 percent. In contrast, for the subperiod1976-1977, which has a large
numberof extreme DERs, the mean estimate of the coefficient of DER including
January is 0.03 percent, with an estimated standard error of 0.02 percent. We
can reject the hypothesis that the coefficient of DER including (excluding)
5% r
0 4%-
3%
4849 50-51 52-53 54-55 56-57 58-59 60-61 62-63 64-65 66-67 68-69 70-71 72-73 74-75 76-77 78-79
Subperiod
Figure 2. Estimated Coefficients of Debt/Equity Ratio by Subperiods-All Firms
5% -
.0 4% -
2%
0%
-3%
-2%-
-3%
4849 50-51 52-53 54-55 56-57 58-59 60-61 62-63 64-65 66-67 68-69 70-71 72-73 74-75 76-77 78-79
Subperiod
the way these portfolios are formed, the maximum (minimum) average DERI
LTEQportfoliousually does not contain all of the largest (smallest) DER/LTEQ
stocks.
Figures 2 and 3 depict the estimated coefficients of DER by subperiodsfor the
1.2% r
0
1%0.9%
0.6%
0.3%
0.0%
-0.3%L 0 0
J F M A M J J A S O N D J F M A M J J A S O N D
Subperiod(Two Years) Months
C. "Incremental"Effects of ExplanatoryVariables
In this subsection, we analyze the effects of inclusion or exclusion of an
explanatoryvariable on the estimated coefficients of the other variables. Table
II summarizesthe results for each possible combinationof explanatoryvariables.
To keep the other things constant, the portfoliosused in all of these combinations
are exactly the same as those used when all of the explanatory variables are
included. In this table, only the results based on the SA estimates are shown
because they provide a better basis for comparison by keeping the subperiod
weights constant across different combinations. Note, however,that the coeffi-
cient of DER excluding January is sometimes not statistically significant based
on the t-statistics in this table, even though it is based on the t-statistics
[E(Qi)
DER DER =
LTEQ, BETA
LTEQ, LTEQ LTEQ, LTEQ, BETA
LTEQ,
BETA, LTEQ
-yo
DER DER DER +
Explanatory
BETA BETA, BETA
DER Estimated
Variables
TyLTEQi
+
0.57 0.57 0.56 0.48 0.68 1.01 0.24 1.28 1.15 0.70 0.27 1.49
Constant
Coefficients
Y2BETA,
+
-0.00
(-0.09) -0.01 Panel -0.11
-0.01 -0.13 -0.13 -0.15Panel
(-0.33) (-0.39) (-3.00) (-2.93)
(-3.33) (-3.29) LTEQ
B: A: All-Firms (Percent
per
Y3DERiJ
0.07
(0.27) 0.13
(0.47) Results0.17 0.49 0.25 0.63 Variables:
Results Sample
(0.60)(1.68) (0.92) (2.15) BETA
Table
UsingII
Month)
0.07 0.07 Excluding
0.13 0.16 0.12 0.16 Including All
(2.17) (1.70) (3.84)(4.02)(3.54) (3.97) DER for
1948-1979a
the
January January
Possible
0.49 1.00 0.58 0.65 0.60 1.45 0.48 1.13 1.44 0.68 0.30 1.42
Constant
0.02
(0.63) -0.04
(-1.06) 0.01
(0.15) -0.12
(-3.32) -0.09
(-2.30) -0.15
(-3.82) -0.13 LTEQ
(-2.87) Expected-Retu
Combinations
of
Manufacturing-Firms
-0.24 -0.04 -0.24 0.21 0.02 0.57
the
(-0.91) (-0.16) (-0.87)
(0.72) (0.08) (1.89) BETA
Equation
Sample
0.05
(0.93) 0.04
(0.54) 0.18
(3.47) 0.23
(3.70) 0.14
(2.48) 0.22 DER
(3.06)
Explanatory
that a
results
the
variables,
in LTEQ,
estimates.
forall LTEQ,
BETA,
Their
each BETA,
coefficient DER
is BETA,
and
zero. combinations DER
t-statistics,
two-year
DER
are
given
in stand
based
for 0.52 0.47
subperiod.
on
The the
parentheses,
0.00
(0.01)
logarithm
areestimated
twenty-seven
of
19The basic reasonis the use of portfoliosformedin a certainway ratherthan the use of individual
securities. Also, the computation of the correct R2 will require the knowledge of the variance-
covariancematrix of uzit'sin (3) up to a constant scalar multiplier.
2 The marketproxies used are the equally weighted and value-weightedportfolios of the NYSE
securities, as well as an extended market portfolio similar to that of Stambaugh[141. The BETA
estimationtechniquesused are OLS and the techniquedevelopedby Scholes and Williams [131.
REFERENCES