Investor heterogeneity, market segmentation, leverage and the equity premium puzzle

Financial economists for the past two decades have attempted to explain why the equity premium is so high, now known as the equity premium puzzle (EPP ). We model investor heterogeneity, market segmentation and optimal leverag e, using the time separable standard power utility, market completeness and ignoring transaction costs to explain the EPP. We explain both the EPP and the related risk-free rate puzzle without resorting to preference modifica tion. Furthermore, we show a unique interior equilibrium for the debt ratio , contrary to the work by F. Modigliani, M.H. Miller (The cost of capital, corporation finance and the theory of investment, American Economic Review 48 (1958) 261-297; Corporate income taxes and the cost of capital, American Economic Review 53 (1963), 433-443) and S.C. Myers (Presidential address: The capital structure puzzle, Journal of Finance 39 (1984), 575-592). Our s imulations show the relevance of our models. (C) 2001 Elsevier Science B.V. All rights reserved.