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Title:Optimal leverage, its benefits, and the business cycle PDF Logo
Authors:Hess, Dieter
Immenkötter, Philipp
Issue Date:2011
Series/Report no.:CFR working paper 11-12
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.
Subjects:capital structure
macroeconomic risk
regime switching
benefit to leverage
JEL:E44
G12
G32
Document Type:Working Paper
Appears in Collections:CFR Working Papers, Centre for Financial Research (CFR), Universität Köln

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