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Title: 

The Risk Anomaly Tradeoff of Leverage

Authors: Baker, Malcom
Hoeyer, Mathias F.
Wurgler, Jeffrey
Keywords: risk anomaly, capital structure, leverage
Issue Date: Mar-2016
Abstract: Higher-beta and higher-volatility equities do not earn commensurately higher returns, a pattern known as the risk anomaly. In this paper, we consider the possibility that the risk anomaly represents mispricing and develop its implications for corporate leverage. The risk anomaly generates a simple tradeoff theory: At zero leverage, the overall cost of capital falls as leverage increases equity risk, but as debt becomes riskier the marginal benefit of increasing equity risk declines. We show that there is an interior optimum and that it is reached at lower leverage for firms with high asset risk. Theoretically and empirically, the risk anomaly tradeoff theory distinguishes itself from the standard tradeoff theory with bankruptcy costs by predicting an inverse relationship between leverage and upside risk, not just downside risk; why numerous firms maintain low or zero leverage despite high marginal tax rates; and, why other firms maintain high leverage despite little tax benefit.
URI: http://hdl.handle.net/2451/34914
Appears in Collections:Finance Working Papers

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