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Fundamental Risk and Capital Structure

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  • Jakub Hajda

    (University of Lausanne and Swiss Finance Institute)

Abstract

I develop a dynamic capital structure model to examine how the nature of risk affects firm’s debt policy. In the model, firm’s fundamental risk, captured by its cash flow process, consists of transitory and persistent parts with markedly different dynamics. The model explains the observed dispersion in the risk-leverage relationship. Firms with similar total volatility adopt distinctive debt policies when the composition of their risk differs and issue less debt when their cash flows are more persistent to preserve debt capacity needed to fund investment. The model also provides rationale why the observable dispersion in cash flow persistence is low, which is at odds with the large degree of heterogeneity in other firm characteristics, as well as why persistence and leverage are weakly related in the data.

Suggested Citation

  • Jakub Hajda, 2017. "Fundamental Risk and Capital Structure," Swiss Finance Institute Research Paper Series 17-50, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1750
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    Keywords

    dynamic capital structure; fundamental risk; transitory and persistent shocks; leverage-risk trade-off;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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