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Introducing Capital Structure in a Production Economy: Implications for Investment, Debt and Dividends

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    This model adds to the standard neoclassical model of business fluctuations by introducing a more realistic capital structure problem, where firms have to balance the tax benefits of debt with the costs of potential financial distress.Therefore, firms solve a dynamic problem with both an investment and a financing decision. This feature allows firms to finance investment through both retained earnings and debt. As a result, debt will increase after a positive shock and dividends will follow a smoother path. This implies that, as pointed by previous empirical evidence, short-term fluctuations in investment are mostly absorbed by debt and not dividends. The capital structure deteriorates first but then improves after a few quarters. In this model, investment is also inversely related to financial leverage.

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    Paper provided by Université de Lausanne, Faculté des HEC, DEEP in its series Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) with number 03.03.

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    Length: 36 pages
    Date of creation: Feb 2003
    Date of revision:
    Handle: RePEc:lau:crdeep:03.03
    Contact details of provider: Postal: Université de Lausanne, Faculté des HEC, DEEP, Internef, CH-1015 Lausanne
    Phone: ++41 21 692.33.20
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