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The firm under uncertainty: capital structure and background risk

  • Broll, Udo
  • Wong, Keith K.P.
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    This paper examines the interplay between the real and financial decisions of the competitive firm under output price uncertainty. The firm faces additional sources of uncertainty that are aggregated into a background risk. We show that the firm always chooses its optimal debt-equity ratio to minimize the weighted average cost of capital, irrespective of the risk attitude of the firm and the incidence of the underlying uncertainty. We further show that the firm's optimal input mix depends on its optimal debt-equity ratio, thereby rendering the interdependence of the real and financial decisions of the firm. When the background risk is either additive or multiplicative, we provide reasonable restrictions on the firm's preferences so as to ensure that the firm's optimal output is adversely affected upon the introduction of the background risk.

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    Paper provided by Dresden University of Technology, Faculty of Business and Economics, Department of Economics in its series Dresden Discussion Paper Series in Economics with number 04/10.

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    Date of creation: 2010
    Date of revision:
    Handle: RePEc:zbw:tuddps:0410
    Contact details of provider: Postal: 01062 Dresden
    Phone: ++49 351 463 2196
    Fax: ++49 351 463 7739
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