Optimal leverage, its benefits, and the business cycle

Dieter Hess and Philipp Immenkötter

No 11-12, CFR Working Papers from University of Cologne, Centre for Financial Research (CFR)

Abstract: We study the effect of the business cycle on optimal capital structure choice and the benefit to leverage. We propose a regime switching model with a state-dependent cash flow process to capture macroeconomic risk in a firm's cash flow. Our model is parsimonious but still realistic and allows for a wide range of analysis. We find pro-cyclical optimal leverage ratios, benefits to leverage, and costs of operating at a non-optimal leverage. If macroeconomic risk decreases, i.e. earnings become more stable and growth rates less volatile, optimal leverage and its benefits increase due to lower default risk. The regime switching property of EBIT traces observed EBIT paths closely and is applicable to a wide range of corporate valuation models. Our model offers novel empirically testable implications, such as higher tax benefits after the change in macroeconomic risk since the late 1980s and common capital structure adjustments in recessions and around turning points.

Keywords: capital structure; macroeconomic risk; regime switching; benefit to leverage (search for similar items in EconPapers)
JEL-codes: E44 G12 G32 (search for similar items in EconPapers)
Date: 2011
New Economics Papers: this item is included in nep-bec and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cfrwps:1112

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