Optimal Capital Structure, Ambiguity Aversion, and Leverage Puzzles

We introduce ambiguity about assets’ value dynamics into a trade-off framework of capital structure to explain the empirically observed zero-leverage and underleverage puzzles. We utilize the decision framework of Chen and Epstein (2002) to characterize investors’ ambiguity aversion. We show that highly ambiguity-averse equity holders perceive that the asset value dynamics of a firm is “too valuable to lose” upon bankruptcy. They optimally choose zero leverage and forgo the tax benefits of debt to avoid possible default. Next, moderately ambiguity-averse equity investors will participate in the debt market, and ambiguity aversion distorts downwards their optimal leverage and debt capacity obtained from the benchmark model with risk aversion only. This distortion effect is stronger (weaker) when a firm’s equity and the debt markets are segmented (integrated). We utilize alternative measures for ambiguity aversion and for market segmentation and find empirical support for our theoretical results.