Fundamental Risk and Capital Structure

Jakub Hajda
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Jakub Hajda: University of Lausanne and Swiss Finance Institute

No 17-50, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: I develop a dynamic capital structure model to examine how the nature of risk affects firm’s debt policy. In the model, firm’s fundamental risk, captured by its cash flow process, consists of transitory and persistent parts with markedly different dynamics. The model explains the observed dispersion in the risk-leverage relationship. Firms with similar total volatility adopt distinctive debt policies when the composition of their risk differs and issue less debt when their cash flows are more persistent to preserve debt capacity needed to fund investment. The model also provides rationale why the observable dispersion in cash flow persistence is low, which is at odds with the large degree of heterogeneity in other firm characteristics, as well as why persistence and leverage are weakly related in the data.

Keywords: dynamic capital structure; fundamental risk; transitory and persistent shocks; leverage-risk trade-off (search for similar items in EconPapers)
JEL-codes: G31 G32 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2017-11
New Economics Papers: this item is included in nep-cfn and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1750

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