Cash flows risk, capital structure, and corporate bond yields
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This paper explores the effects of a firm’s cash flow systematic risk on its optimal capital structure. In a model where firms are allowed to borrow resources from a competitive lending sector, those with cash flows more correlated with the aggregate economy (i.e., firms with riskier assets in place) choose a lower leverage given their higher expected financing costs. On the other hand, less risky firms, having lower expected financing costs, optimally choose to issue more debt to exploit a tax advantage. The model predicts that cash flow systematic risk is negatively correlated with leverage and corporate bond yields.
KeywordsSystematic risk Optimal capital structure Assets prices
JEL ClassificationG12 G32 D92
I am very grateful to Rui Albuquerque, Harjoat Bhamra, Barbara Bukhvalova, Andrea Buffa, Gian Luca Clementi, Dirk Hackbart, Siamak Javadi, Evgeny Lyanders, David McLean, Angelo Mele, Allen Michel, Ali Ozdagli, Marco Rossi, Lukas Schmid, Philip Strahan, Adam Zawadowski, as well as seminar attendants at Boston University, Green Line Macroeconomics Meeting, Midwest Finance Association, Society for Economics Dynamics, University of Alberta, and BI Oslo for their comments and suggestions. The views expressed are those of the author and do not necessarily reflect those of the Federal Reserve Board or the Federal Reserve System.