In this paper we investigate the theoretical relation between financial leverage and stock returns in a dynamic world where both the corporate investment and financing decisions are endogenous. We find that the link between leverage and stock returns is more complex than the static textbook examples suggest and will be determined by the interplay of the firm’s investment opportunities and default risk which vary systematically with macroeconomic conditions. In the presence of financial market imperfections leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer (risky) growth opportunities. We first formalize this in a simple continuous-time model and then show that a quantitative version of our model can replicate both the evidence in Bhandari (1988) and Fama and French (1992) about the effects of leverage on returns and the results in Welch (2004) about the impact of returns on leverage ratios.
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