Optimal Capital Structure, Ambiguity Aversion, and Leverage Puzzles

45 Pages Posted: 7 Oct 2020 Last revised: 16 Apr 2021

See all articles by Sami Attaoui

Sami Attaoui

NEOMA Business School

Wenbin Cao

NEOMA Business School

Xiaoman Duan

Sam Houston State University - Department of General Business and Finance

Hening Liu

University of Manchester - Alliance Manchester Business School

Date Written: August 19, 2020

Abstract

We introduce ambiguity about the asset value dynamics of a firm into a trade-off framework of capital structure. We characterize investors' preferences by recursive multiple priors utility. We show that equity holders' ambiguity aversion significantly reduces the optimal leverage and debt capacity. In particular, equity holders with sufficiently strong ambiguity aversion perceive their asset value dynamics to be "too valuable to lose" upon bankruptcy and therefore optimally choose zero leverage and forgo the tax benefits of debt to avoid possible default. We also show that the distortion effect of ambiguity on the leverage choice is stronger (weaker) when a firm's equity and debt markets are segmented (integrated).

Keywords: Ambiguity aversion, debt conservatism, trade-off theory, market segmentation

JEL Classification: G32

Suggested Citation

Attaoui, Sami and Cao, Wenbin and Duan, Xiaoman and Liu, Hening, Optimal Capital Structure, Ambiguity Aversion, and Leverage Puzzles (August 19, 2020). Available at SSRN: https://ssrn.com/abstract=3676905 or http://dx.doi.org/10.2139/ssrn.3676905

Sami Attaoui

NEOMA Business School ( email )

Boulevard André Siegfried - BP 215
Mont Saint Aignan, 76825
France

Wenbin Cao (Contact Author)

NEOMA Business School ( email )

1 Rue du Maréchal Juin
Mont Saint Aignan Cedex, 76825
France

Xiaoman Duan

Sam Houston State University - Department of General Business and Finance ( email )

United States

Hening Liu

University of Manchester - Alliance Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

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