(Revised March 2024)

The empirical connection between financial leverage and equity risk premia is surprisingly weak. We link limited financial flexibility to levered risk premia with a quantitative model, where firms make dynamic investment, financing, and default decisions. Our model spotlights two variables, leverage gaps and leverage targets, as drivers of risk premia. Firms partially close the gap toward their target, being optimally over- or under-levered. Equityholders of over-levered firms bear higher costs of debt, as their capital structure is vulnerable to bankruptcy costs. Hence, gaps contribute to the amplification of asset returns. The “lost” leverage risk premium reappears after controlling for targets.