Financial Inflexibility and the Value Premium

Abstract

This paper tests whether and to what extent the value premium is induced by financial inflexibility risk. 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.

Keywords: Financial flexibility, value premium, fixed assets, leverage, financial constraints