Knightian Uncertainty and Capital Structure: Theory and Evidence

Abstract

I derive the optimal capital structure of a rm when its manager is ambiguity-averse. My model predicts substantially lower leverage for such rms, in comparison to traditional trade-o models. I use the 1982 Voluntary Restraint Agreement (VRA) on steel import quotas between the U.S. government and the European Community as an exogenous reduction in Knightian uncertainty faced by rms in the U.S. steel industry. Using a dierence-in-dier ence methodology, I nd that when uncertainty is resolved, a median rm in the U.S. steel industry increases its market and book leverage by approximately 12% relative to a matched control rm from another industry. The results are not explained away by changes in traditional risk factors or by a change in expected future protability.