Levered Returns and Capital Structure Imbalances

Filippo Ippolito and Alessandro Villa
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Alessandro Villa: https://www.chicagofed.org/people/v/villa-alessandro

No WP 2022-42, Working Paper Series from Federal Reserve Bank of Chicago

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 (search for similar items in EconPapers)
JEL-codes: G12 G32 (search for similar items in EconPapers)
Pages: 63
Date: 2022-01-08
New Economics Papers: this item is included in nep-cfn and nep-rmg
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