Robust leverage dynamics without commitment

This paper analyzes the dynamic capital structure choices with model uncertainty. We find that robustness concerns from shareholders and creditors have distinct implications. Creditor ambiguity aversion allows a firm to take advantage of the debt tax shield in no-commitment equilibrium because ambiguity aversion serves as a commitment device that disciplines the leverage ratchet effect and even results in debt buybacks. In contrast, shareholder ambiguity aversion mitigates overborrowing incentives only when the default option is out-of-the-money. If the default option is sufficiently in-the-money, ambiguity-averse shareholders are tempted to adopt a more aggressive debt policy because they can transfer model uncertainty to creditors upon default. Interestingly, we show that the commitment against future debt dilution could be suboptimal because of inefficient ambiguity sharing. Finally, we highlight that model uncertainty and volatility have distinct impacts on target leverage, default, and debt capacity.