The Relationship between Financial Leverage and Beta on Equity Valuation Model

Modigliani and Miller's(MM's) second proposition allows us to infer that leverage is directly related to expected returns to equity through its impact on equity beta. Hence, if CAPM is sound, we would not expect to find leverage to be a significant explanatory variable in a multiple regression of returns on earnings, beta and leverage, assuming that the model was otherwise well-specified. The results from a regression of returns on earnings, Beta and leverage following the model show that the coefficient on earnings is of the predicted sign and significant at the one percent level. The coefficients on the Beta and leverage variables are negative and positive respectively, but insignificant. This is only partially consistent with CAPM and MM interpretation, therefore.