(Revised April 2025)
The empirical connection between financial leverage and equity risk premia is surprisingly weak. We propose a quantitative model linking limited financial flexibility to levered risk premia, where firms make dynamic investment, financing, and default decisions. The model highlights two key variables, leverage gaps and leverage targets, as drivers of risk premia. Firms partially close the gap toward their target, remaining optimally over- or under-levered. Equityholders of overlevered firms face higher debt costs, as their capital structure becomes more exposed to bankruptcy risk. As a result,leverage gaps amplify asset returns. The “lost” leverage risk premium reappears after controlling for targets.