Levered Returns

In this paper we investigate the theoretical relation between financial leverage and stock returns in a dynamic world where both the corporate investment and finance decisions are endogenous. We find that the link between leverage and stock returns is more complex than the static textbook examples suggest and will usually depend on the investment opportunities available to the firm. In the presence of financial market imperfections leverage and investment are generally correlated so that highly levered firms are also mature firmswith relatively more (safe) book assets and fewer (risky) growth opportunities. We show that a quantitative version of our model can successfully replicate the empirical relationships between leverage and returns, even after one controls for variables such as size and book to market.