Corporate financing policies, financial leverage, and stock returns

We examine the interaction between equity returns and firms’ financing policies in a stochastic Ramsey model with heterogeneous firms. Motivated by empirical evidence, firms maintain stationary financial leverage ratios by issuing debt. We present a novel closed-form solution to this class of models and, subsequently, use this solution to show that restricting firms’ financing policies can explain various stylized facts of both the dynamic as well as the cross-sectional behavior of equity returns. Our restrictions induce persistent and countercyclical heteroskedasticity in returns, predictability by dividend–price ratios, a security market line that is “too flat”, and mean-reverting CAPM betas that correlate with leverage. Our model explains both established as well as recent empirical evidence, but challenges recent theoretical macro-finance explanations of the link between capital structure and equity returns.