Uncertainty, Major Investments, and Capital Structure Dynamics

Abstract

This study examines the effects of uncertainty on firms' capital structure dynamics. We find that high-uncertainty firms have substantially lower target leverage while those firms' leverage adjustment speeds increase only if they are over-levered. We show that when facing large investment needs, over-levered firms with high uncertainty converge to their targets substantially faster to avoid bankruptcy whereas those with low uncertainty tend to deviate from their targets due to the transitory debt financing of the investments, thereby reconciling two opposing leverage dynamics documented in the literature. On the other hand, under-levered firms with high uncertainty converge to their targets more slowly than those with low uncertainty due to the increased value of the option to wait and see. Further investigation of the leverage adjustment behavior of over- and under-levered firms in relation to uncertainty provides evidence that bankruptcy threat, agency costs, and real option channels account for various aspects of leverage dynamics.