Optimal Leverage, its Benets, and the Business Cycle

We study the eect of the business cycle on optimal capital structure choice and thebenet to leverage. We propose a regime switching model with a state-dependentcash ow process to capture macroeconomic risk in a rm's cash ow. Our modelis parsimonious but still realistic and allows for a wide range of analysis. We ndpro-cyclical optimal leverage ratios, benets to leverage, and costs of operating at anon-optimal leverage. If macroeconomic risk decreases, i.e. earnings become morestable and growth rates less volatile, optimal leverage and its benets increase dueto lower default risk. The regime switching property of EBIT traces observed EBITpaths closely and is applicable to a wide range of corporate valuation models. Ourmodel oers novel empirically testable implications, such as higher tax benets afterthe change in macroeconomic risk since the late 1980s and common capital structureadjustments in recessions and around turning points.