Working Paper

Levered Returns and Capital Structure Imbalances

Abstract: We revisit the relation between equity returns and financial leverage through the lens of a dynamic trade-off model with costly capital structure rebalancing. The model predicts that expected equity returns depend on whether a firm's leverage is above or below its target leverage. We provide empirical evidence in support of the model predictions. Controlling for leverage, overlevered (underlevered) firms earn higher (lower) returns. A quantitative version of our model reproduces key facts about capital structure rebalancing and equity returns for U.S. corporations. Overall, our results indicate that financial flexibility crucially affects the link between leverage and equity returns.

Keywords: Leverage; Cross Section of Returns; Dynamic Capital Structure; Financial Frictions;

JEL Classification: G12; G32;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2022-01-08

Number: WP 2022-42