Optimal investment and capital structure under Knightian uncertainty

Yaoyao Wu and Fan Hu

International Review of Financial Analysis, 2024, vol. 95, issue PB

Abstract: We extend the standard capital structure and real option models by incorporating Knightian uncertainty. We obtain closed-form solutions for the optimal capital structure and investment decisions. Our findings reveal that in contrast to traditional uncertainty in the form of risk, Knightian uncertainty induces the entrepreneur to take higher firm leverage by issuing more debt, which results in a higher credit spread and higher default risk. In the investment decision, Knightian uncertainty may result in under-investment or over-investment. This result is different from the all-equity financing case, where Knightian uncertainty always leads to under-investment. Finally, when Knightian uncertainty exists, an entrepreneurial firm with more volatile cash flow may choose higher leverage, which is in contrast to the standard capital structure model.

Keywords: Knightian uncertainty; Investment; Capital structure; Endogenous default; Leverage ratio (search for similar items in EconPapers)
JEL-codes: D81 E22 G30 (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S1057521924003831
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:95:y:2024:i:pb:s1057521924003831

DOI: 10.1016/j.irfa.2024.103451

Access Statistics for this article

International Review of Financial Analysis is currently edited by B.M. Lucey

More articles in International Review of Financial Analysis from Elsevier
Bibliographic data for series maintained by Catherine Liu ().