Does the debt load of a company have an impact on the stock price of a company and its volatility? Also, how does the market react to the announcement of a company issuing bonds?


Q1 - Yes, debt load has an impact on the stock price. For instance, say you are valuing a company with a discounted cash flow model, while the interest won't affect the operational cash flows, it will increase the cost of capital. With that, the perceived value will be less than a similar company with less debt. Debt will also affect the volatility of the equity. As debt becomes a larger portion of the old Assets = Liabilities + Equity equation, changes in asset value will have a larger sway on Equity.

Q2 - Depends. If the market perceives that the company needs more debt to fund capital expenditures due to opportunity, then the market should react positively. If they're issuing debt and the market thinks this is a poor choice, the market with punish the stock. As a caveat, if they issue debt to buy back stock the market will almost always act positively due to less shares for trade.


The standard theoretical model for examining this question is the Merton Model. The Merton Model views the company's equity as a call option on its assets.

This model assumes that a company has a certain amount of zero-coupon debt that will become due at a future time T. The company defaults if the value of its assets is less than the promised debt repayment at time T. The equity of the company is a European call option on the assets of the company with maturity T and a strike price equal to the face value of the debt.

Hence the equity volatility for a company with very low debt converges to the asset volatility, since the equity value (call option price) is about equal to the total assets. As the debt load rises, the option becomes closer to the money, and, assuming total assets remain unchanged, the equity value shrinks. If the underlying volatility of the assets also remains essentially unchanged, then the volatility of the equity increases as asset volatility is larger relative to the lower equity value.

The Merton Model has been shown to be a empirically accurate for non-financial firms.


Let's start with an empirical test of the relationship between leverage and stock price returns and see if this connects to corporate finance theory.

Below is a bivariate chart that show the one-year forward return of a security vs. leverage. The x-axis is the leverage characteristic "Total Liabilities to Total Assets" in the current quarter. The characteristic is binned in six equally sized buckets and the harmonic mean of the one-year forward return is the y-coordinate of each dot. The population is S&P 500 securities from 2004 to mid-2011.

Notice there is U-shape relationship between leverage and returns. Some observations:

  1. Firms with top quartile (right-most bin) debt have the worst forward returns.

  2. Firms with very low debt (left-most bin) have low returns

  3. The Goldilocks firms in the middle have higher returns.

How to reconcile this with theory? This confirms Miller & Modigliani propositions in a world with taxes (where interest expense is tax-deductible). On the margin, firms can increase enterprise value by generate a tax shield by increasing leverage. However, an indifference point is reached where the benefits of marginal debt are offset by the marginal increase of default. This is also called static trade-off theory (and investment bankers and CFOs think hard about this optimal capital structure problem).

This is why you see firms in bucket 4 have the highest returns. With some simplification in this static analysis, you can argue that firms to the left of this bucket can benefit from increasing leverage and firms to the right should de-lever.

All things being equal, as firms increase leverage the volatility of their earnings and therefore the volatility of the share price.

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The last part of your question regarding market perception to debt issuance is related to Pecking Order theory. The theory starts in a principal-agent world where agents (firm managers) have more information regrading the firm than their principals (shareholders). The wikipedia link is a bit light - but the idea is that managers will prefer forms of raising capital that reveal the least amount of information as possible. Cash from operations reveals the least amount of information whereas equity issuance reveals the most. Managers that issue stock may be revealing information that their share price is overvalued whereas managers that have favorable views of the firm prospects would favor issuance of debt.

Finally, take a look at Jensen's Free Cash Flow hypothesis. Jensen argues that debt constrains manager behavior by removing discretion in the use of cashflows which therefore leads to better shareholder value creation.


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