Fundamental risk and capital structure

I develop a dynamic capital structure model to examine how the nature of risk affects firm's debt policy. In the model, firm's fundamental risk, captured by its cash flow process, consists of transitory and persistent parts with markedly different dynamics. The model explains the observed dispersion in the risk-leverage relationship. Firms with similar total volatility adopt distinctive debt policies when the composition of their risk differs and issue less debt when their cash flows are more persistent to preserve debt capacity needed to fund investment. The model also provides rationale why the observable dispersion in cash flow persistence is low, which is at odds with the large degree of heterogeneity in other firm characteristics, as well as why persistence and leverage are weakly related in the data