Levered Returns and Capital Structure Imbalances
64 Pages Posted: 24 Jan 2017 Last revised: 15 May 2018
Date Written: March 4, 2017
We revisit the relation between equity returns and financial leverage through the lens of a trade-off model with costly capital structure rebalancing. The model provides a “lookalike” Modigliani-Miller equation that predicts that expected equity returns depend on whether a firm’s leverage is above or below its target leverage. The data support the model predictions. Controlling for leverage, overlevered (underlevered) firms earn higher (lower) returns. Controlling for target leverage the textbook positive relationship between leverage and returns is restored, while target leverage is negatively related to returns.
Keywords: Leverage, Cross Section of Returns, Target Leverage, Dynamic Capital Structure, Financial Frictions
JEL Classification: G12, G32
Suggested Citation: Suggested Citation