Capital Structure under Heterogeneous Beliefs

Abstract

Abstract We develop a structural model to quantitatively analyze the effects of asymmetric beliefs and agency conflicts on capital structure. Capital structure reflects the dynamic tradeoff between the positive incentive effects of managerial optimism and the negative effects of risk-sharing costs. Consistent with empirical evidence, long-term debt declines with optimism, whereas short-term borrowing increases. Permanent and transitory risk components have contrasting effects. Long-term debt increases with the intrinsic risk, but varies nonmonotonically with the transient risk. Short-term borrowing declines with the intrinsic risk, but increases with the transient risk. Overall, our findings show that asymmetric beliefs significantly influence firms’ financial policies.