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

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.