Optimal investment and capital structure under Knightian uncertainty

We extend the standard capital structure and real option models by incorporating Knightian uncertainty. We obtain closed-form solutions for the optimal capital structure and investment decisions. Our findings reveal that in contrast to traditional uncertainty in the form of risk, Knightian uncertainty induces the entrepreneur to take higher firm leverage by issuing more debt, which results in a higher credit spread and higher default risk. In the investment decision, Knightian uncertainty may result in under-investment or over-investment. This result is different from the all-equity financing case, where Knightian uncertainty always leads to under-investment. Finally, when Knightian uncertainty exists, an entrepreneurial firm with more volatile cash flow may choose higher leverage, which is in contrast to the standard capital structure model.