Knightian Uncertainty and Capital Structure: Theory and Evidence

64 Pages Posted: 31 Oct 2014 Last revised: 25 Mar 2017

See all articles by Seokwoo Lee

Seokwoo Lee

University of Maryland - Robert H. Smith School of Business

Date Written: March 18, 2017

Abstract

I derive the optimal capital structure of a firm when its manager is ambiguity-averse. My model predicts substantially lower leverage for such firms, in comparison to traditional trade-off models. I use the 1982 Voluntary Restraint Agreement (VRA) on steel import quotas between the U.S. government and the European Community as an exogenous reduction in Knightian uncertainty faced by firms in the U.S. steel industry. Using a difference-in-difference methodology, I find that when uncertainty is resolved, a median firm in the U.S. steel industry increases its market and book leverage by approximately 12% relative to a matched control firm from another industry. The results are not explained away by changes in traditional risk factors or by a change in expected future profitability.

Keywords: Knightian Uncertainty, Optimal Capital Structure, Voluntary Restraint Agreement (VRA), Difference-in-Difference

Suggested Citation

Lee, Seokwoo, Knightian Uncertainty and Capital Structure: Theory and Evidence (March 18, 2017). Available at SSRN: https://ssrn.com/abstract=2516526 or http://dx.doi.org/10.2139/ssrn.2516526

Seokwoo Lee (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States

HOME PAGE: http://https://sites.google.com/a/umich.edu/seokwoo-lee/home

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