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 provides 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