Ambiguity and the Tradeoff Theory of Capital Structure

Abstract

We examine the impact of ambiguity, or Knightian uncertainty, on the capital structure decision, using a static tradeoff theory model in which agents are both ambiguity and risk averse. The model confirms the well-known result that greater risk—the uncertainty over outcomes—leads firms to decrease leverage. Conversely, the model indicates that greater ambiguity—the uncertainty over the probabilities associated with the outcomes—leads firms to increase leverage. Using a theoretically based measure of ambiguity, our empirical analysis presents evidence consistent with these notions, showing that ambiguity has an important and distinct impact on capital structure. This paper was accepted by Gustavo Manso, finance.

Optimal capital structure, ambiguity aversion, and leverage puzzles

“…Contrary to our model,Izhakian et al (2021) shows that the optimal leverage increases in ambiguity. We find qualitatively the same result in a hypothetical case of our model in which both equity investors and debt investors price their holdings with the worst-case measure of equity investors.…”

“…Our paper is closely related to several papers on optimal capital structure. Lee (2016Lee ( , 2017 and Izhakian et al (2021) also study optimal capital structure under ambiguity. However, none of them has ZL as an equilibrium outcome.…”

“…However, none of them has ZL as an equilibrium outcome. Both Lee (2017) and Izhakian et al (2021) utilize a one-period trade-off framework with alternative frameworks for modelling ambiguity. Because the utility preferences that they adopt are inherently smooth, the optimal leverage in their models is always positive.…”

Beyond Risk: Voluntary Disclosure Under Ambiguity

“…Overall, I show that the change in monthly ambiguity is weakly correlated with various measures of financial and economic uncertainty. This suggests that ambiguity captures a distinctly unique aspect of firm-level financial and economic uncertainty, which coincides with the comprehensive tests in recent literature (e.g., Brenner & Izhakian, 2018;Augustin & Izhakian, 2020;Izhakian et al, 2021). More precisely, previous ambiguity literature has found that various firm-level characteristics (Izhakian et al, 2021) or events (Doan et al, 2018;Ben-Rephael and Izhakian, 2020) may be related to ambiguity (distinctly from risk).…”

“…The positive correlation is to be expected, since changes in the macro-economic and political environment, which are captured by EPU, influence and change firms' information environment (Baker et al, 2016;Nagar et al, 2019). For example, uncertainty about a new regulation increases ambiguity in related firms in an industry (Izhakian et al, 2021).…”