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Ambiguity and the Tradeoff Theory of Capital Structure

We examine the impact of ambiguity, or Knightian uncertainty, on the capital structure decision, using a static tradeoff theory model in which agents are both ambiguity and risk averse. The model confirms the well-known result that greater risk—the uncertainty over outcomes—leads firms to decrease leverage. Conversely, the model indicates that greater ambiguity—the uncertainty over the probabilities associated with the outcomes—leads firms to increase leverage. Using a theoretically based measure of ambiguity, our empirical analysis presents evidence consistent with these notions, showing that ambiguity has an important and distinct impact on capital structure. This paper was accepted by Gustavo Manso, finance.