The purpose of this paper is to investigate whether higher asset risk can be associated with higher leverage and to provide a rationale for the relatively low debt ratios displayed by many firms.
A game is modeled between an informed firm and uninformed lenders. The firm knows the risk of its assets, while lenders only know the minimum level of risk. The author solves for the signaling equilibrium and derive explicit formulas for the firm’s cost of debt and optimal leverage.
In contrast to the tradeoff theory of capital structure, it is found that asset risk and leverage are positively (instead of negatively) related. Furthermore, leverage is lower than when lenders are informed about the firm’s risk. These results are illustrated with a numerical example.
Low-risk firms can choose a lower leverage to signal their lower risk and reduce their cost of debt. High-risk firms may prefer to pay higher interest rates and use higher leverage.
The paper is able to explain why some firms use surprisingly low leverage and do not appear to take advantage of their debt tax shields.
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