Knightian Uncertainty and Dynamic Capital Structure
30 Pages Posted: 27 Dec 2018
Date Written: October 1, 2016
I incorporate ambiguity-averse equity-holders who are uncertain about the distribution of a firm’s assets into the dynamic capital structure model of Leland (1994). My model shows the optimal default threshold increases with Knightian uncertainty, whereas it decreases with risk. When the effect of uncertainty dominates that of risk, a firm optimally defaults earlier than predicted by a traditional dynamic model with risk alone. My ambiguity-augmented model predicts substantially lower leverage ratios, in comparison to the benchmark model of Leland (1994).
Keywords: Ambiguity-Aversion, Real Option, Dynamic Capital Structure
Suggested Citation: Suggested Citation