Knightian Uncertainty and Capital Structure

Abstract

My dissertation aims to understand a firm's optimal capital structure decision when it confronts Knightian uncertainty. It contains three chapters. In Chapter One, I derive the optimal capital structure of a firm when its manager is ambiguity-averse. My model predicts substantially lower leverage for such firms, in comparison to traditional static trade-off 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 firms in the U.S. steel industry. Using a difference-in-difference methodology, I find that when uncertainty is resolved, a median firm in the U.S. steel industry increases its market and book leverage by approximately 12 percent relative to a matched control firm from another industry. The results are not explained away by changes in traditional risk factors or by a change in expected future profitability. In Chapter Two, I develop a new measure of Knightian uncertainty using a mixture of normal distributions. Using this novel measure, I find that a median firm in the sample decreases its market leverage by approximately 3.6 percent, when the firm's measure of uncertainty increases by one standard deviation. I also find an increase in a firm's uncertainty measure from the minimum to the maximum is associated with a 6.3 percent increase in the firm's propensity to take almost zero leverage. In Chapter Three, I consider a firm's decision to exercise real options, when the firm faces Knightian uncertainty about the evolution of project value. I provide two continuous time applications extended from the discrete time applications in Miao and Wang (2011) that show the value of waiting (which increases with risk) decreases with uncertainty. I incorporate ambiguity-averse investors who are uncertain about the evolution of a firm's assets into the dynamic capital structure model of Leland (1994). I show that even in this dynamic setting, uncertainty provides a more plausible explanation for firms taking on low leverage than risk alone.