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 net 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 negative correlated with net leverage and corporate bond yields