Ambiguity and The Trade Off Theory of Capital Structure

Yehuda Izhakian, David Yermack, and Jaime Zender

Abstract

We examine the importance of ambiguity, or Knightian uncertainty, in the capital structure decision. We develop a static tradeoff theory model in which agents are both risk averse and ambiguity averse. The model confirms the usual idea that increased risk---the uncertainty over known possible outcomes---leads firms to use less leverage. Conversely, greater ambiguity---the uncertainty over the probabilities associated with the outcomes---leads firms to increase leverage. Our empirical analysis provides results consistent with these predictions.