Abstract
The costs of financial distress suggest that business risk and optimal leverage should be inversely related. However, empirical studies have generally found this connection to be weak. We exploit the predictable changes in asset volatility following corporate acquisition to identify the effect of business risk on capital structure. Our estimates suggest that a one standard deviation decline in asset volatility leads to as much as a 10.3 percentage point increase in leverage. In addition, we find asset volatility strongly predicts cash holdings and the payment method. Our results suggest that business risk is a first-order determinant of firms' financial policy.
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