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Optimal leverage, its benefits, and the business cycle

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  • Hess, Dieter
  • Immenkötter, Philipp

Abstract

We study the effect of the business cycle on optimal capital structure choice and the benefit to leverage. We propose a regime switching model with a state-dependent cash flow process to capture macroeconomic risk in a firm's cash flow. Our model is parsimonious but still realistic and allows for a wide range of analysis. We find pro-cyclical optimal leverage ratios, benefits to leverage, and costs of operating at a non-optimal leverage. If macroeconomic risk decreases, i.e. earnings become more stable and growth rates less volatile, optimal leverage and its benefits increase due to lower default risk. The regime switching property of EBIT traces observed EBIT paths closely and is applicable to a wide range of corporate valuation models. Our model offers novel empirically testable implications, such as higher tax benefits after the change in macroeconomic risk since the late 1980s and common capital structure adjustments in recessions and around turning points.

Suggested Citation

  • Hess, Dieter & Immenkötter, Philipp, 2011. "Optimal leverage, its benefits, and the business cycle," CFR Working Papers 11-12, University of Cologne, Centre for Financial Research (CFR).
    • Handle: RePEc:zbw:cfrwps:1112
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    References listed on IDEAS

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    Cited by:

    1. Correia, Ricardo & Población, Javier, 2015. "A structural model with Explicit Distress," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 112-130.

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    More about this item

    Keywords

    capital structure; macroeconomic risk; regime switching; benefit to leverage;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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