Knightian Uncertainty and Capital Structure: Theory and Evidence
64 Pages Posted: 31 Oct 2014 Last revised: 25 Mar 2017
Date Written: March 18, 2017
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
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