Knightian Uncertainty and Dynamic Capital Structure

30 Pages Posted: 27 Dec 2018

See all articles by Seokwoo Lee

Seokwoo Lee

University of Maryland - Robert H. Smith School of Business

Date Written: October 1, 2016

Abstract

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

Lee, Seokwoo, Knightian Uncertainty and Dynamic Capital Structure (October 1, 2016). George Mason University School of Business Research Paper No. 19-4, Available at SSRN: https://ssrn.com/abstract=3299020 or http://dx.doi.org/10.2139/ssrn.3299020

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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