Cash flows risk, capital structure, and corporate bond yields

This paper explores the effects of a firm's cash flow systematic risk on its optimal capital structure. In a model where firms are allowed to borrow resources from a competitive lending sector, those with cash flows more correlated with the aggregate economy (i.e., firms with riskier assets in place) choose a lower leverage given their higher expected financing costs. On the other hand, less risky firms, having lower expected financing costs, optimally choose to issue more debt to exploit a tax advantage. The model predicts that cash flow systematic risk is negatively correlated with leverage and corporate bond yields.