Learning-Based Theory of Financing

Abstract

We develop a dynamic structural model of optimal investment, financing and payouts where firms learn progressively about their true exposure to a catastrophic shock. Beliefs are a latent state variable, becoming more favorable the longer the firm has avoided a negative shock, with major downward revisions after a negative shock. In this setting, firms initially behave conservatively in terms of reliance on debt, which may provide a partial explanation for the low-leverage puzzle. Further, learning generates equity returns exhibiting long and heavy left tails. Finally, in a setting where firms learn about common exposure to catastrophic macroeconomic shocks, leverage cycles are amplified.