Leverage and the Beta Anomaly

The well-known weak empirical relationship between beta risk and the cost of equity--thebeta anomaly--generates a simple tradeoff theory: As firms lever up, the overall cost ofcapital falls as leverage increases equity beta, but as debt becomes riskier the marginalbenefit of increasing equity beta declines. As a simple theoretical framework predicts, wefind that leverage is inversely related to asset beta, including upside asset beta, which ishard to explain by the traditional leverage tradeoff with financial distress that emphasizesdownside risk. The results are robust to a variety of specification choices and controlvariables