Economic Policy Uncertainty and Dynamics of Capital Structure

Abstract

We examine the role of firm-level political risk in the capital structure dynamics for the U.S. listed firms from 2002 to 2017. We find that firm-level political risk facilitates firms' speed of adjustment towards its target leverage, and such a positive effect holds for categorical political risk. We also find that the positive effect is visible in overleveraged firms. Additionally, the cost of equity sensitivity and value of financial flexibility are identified as the possible mechanisms. The results remain intact after addressing identification issues and are robust to alternative leverage measures, model specifications, and estimation techniques. Our findings highlight the importance of accounting for heterogeneous exposure to political risk in capital structure dynamics.