Abstract
We introduce ambiguity about the asset value dynamics of a firm into a trade-off framework of capital structure. We characterize investors' preferences by recursive multiple priors utility. We show that equity holders' ambiguity aversion significantly reduces the optimal leverage and debt capacity. In particular, equity holders with sufficiently strong ambiguity aversion perceive their asset value dynamics to be too valuable to lose upon bankruptcy and therefore optimally choose zero leverage and forgo the tax benefits of debt to avoid possible default. We also show that the distortion effect of ambiguity on the leverage choice is stronger (weaker) when a firm's equity and debt markets are segmented (integrated).
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