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Capital structure and the firm under uncertainty

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  • Broll, Udo
  • Wong, Kit Pong

Abstract

This paper examines the interplay between the real and financial decisions of the competitive firm `a la Sandmo. Besides output price uncertainty, the firm faces additional sources of risk which are aggregated into an additive background risk. We show that the firm always chooses its optimal debt-equity ratio to minimize the weighted average cost of capital, irrespective of the risk attitude of the firm and the incidence of the multiple sources of uncertainty. Even though the introduction of the background risk affects neither the optimal debt-equity ratio nor the marginal rate of technical substitution, it does have an adverse effect on the output level of the firm. Furthermore, if capital is a normal input, the presence of the background risk induces the firm to acquire less capital by issuing less debt and equity.

Suggested Citation

  • Broll, Udo & Wong, Kit Pong, 2003. "Capital structure and the firm under uncertainty," Dresden Discussion Paper Series in Economics 20/03, Technische Universität Dresden, Faculty of Business and Economics, Department of Economics.
    • Handle: RePEc:zbw:tuddps:2003
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Background risk; Capital structure; Price uncertainty;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • 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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