Capital Structure Dynamics and Market Implications: Determinants of Leverage and Capital Structure Volatility, and Their Effects on Stock Returns

Abstract

This thesis investigates how firm-specific characteristics influence both leverage and capital structure volatility (CSV), and whether these two dimensions of capital structure help explain stock return performance. Using a dataset of Nasdaq Composite Index-listed firms from 2005 to 2024, the study applies fixed effects regressions to examine the determinants of leverage and CSV and employs both time-series and cross-sectional regressions on asset pricing models to test their relationship with equity returns. The findings reveal that firm fundamentals significantly shape leverage and CSV, though the direction and strength of these relationships vary across variables and sectors. This thesis finds that leverage is positively related to asset tangibility, growth opportunities, firm size, earnings volatility, and age, and negatively related to profitability, non-debt tax shields, and interest rates. Furthermore, CSV is found to be positively associated with leverage and earnings volatility, while negatively related to profitability, size, and age. Notably, determinants of leverage and CSV vary across sectors. In terms of market implications, leverage offers limited explanatory power for stock returns. Although the leverage factor (LEV_HML) displays some significance under the Carhart four- factor model, the results lack robustness, and leverage is not supported as an empirical risk factor in Fama-MacBeth regressions. Conversely, CSV shows stronger asset pricing relevance. While individual CSV portfolios do not exhibit significant alphas, the CSV factor (CSV_HML) generates statistically significant negative abnormal returns under both the Fama-French five- factor and Carhart four-factor models. Fama-MacBeth results further suggest that CSV may act as an empirical risk factor, particularly at the extremes of the volatility distribution. Overall, the thesis contributes to capital structure literature by demonstrating that CSV may serve as a more meaningful indicator of financial risk than leverage. The results imply that investors penalize firms with unstable capital structure behavior, especially when financial volatility arises in firms previously perceived as stable. These findings underscore the importance of financial stability in shaping stock return expectations and call for further research into the dynamic behavior of capital structure.