Cash-Flow Risks, Financial Leverage and the Cross Section of Equity Returns

What is the cross-sectional relationship between financial leverage and expected equity returns? How is the empirical relationship associated with firm's financial decisions? This paper investigates the potential explanations for the flatness relation between financial leverage and expected equity returns, and its link to firms' capital structure determinants. Empirical evidence contradicts the theoretical prediction that leverage amplifies the equity risks. I decompose expected equity returns of book leverage portfolios according to their exposure to cash flow and discount rate risk. I find that low leverage firms have lower cash-flow beta and higher discount-rate beta than firms with high leverage. Although cash-flow beta typically has a higher price of risk, book leverage portfolios load disproportionately on discount-rate beta, generating an essentially flat relation. Moreover, the main determinants of firms' capital structures are related to firms' sensitivities to these systematic sources of risk and they affect asymmetrically low and high leverage firms. I show that temporary shocks are relatively more important for low leverage firms, and that financial distress risk seems to be captured by the sensitivity of firms' cash flow innovations to market discount rate news