In a multifactor model of expected equity return of a levered firm, the equity beta equals firm beta multiplied by the elasticity of equity price with respect to firm value. This elasticity is, in general, increasing in leverage and it is time varying due to time variation in leverage ratio (the capital structure effect).
This paper examines, theoretically and empirically, the hypothesis that the capital structure effect causes of the following empirical regularities reported in existing literature: 1) the cross-sectional relation between size, book-to-market, and average equity return and 2) reversal in long-horizon and momentum in medium-horizon equity returns. The capital structure effect is measured and distinguished from other existing explanations mainly by comparing tests of equity and firm returns of the same set of firms. We find that firm returns are not related to size or book-to-market; 50% of the explanatory power of size and 70% of the explanatory power of book-to-market for average equity returns are due to the capital structure effect. Moreover, the capital structure effect explains away reversal in long-horizon equity returns, and due to the capital structure effect. Moreover the capital structure effect explains away reversal in long-horizon equity returns, and it explains 40% of momentum in medium-horizon equity returns.
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