An important piece of the capital structure puzzle has been missing, and it is not a contracting friction. It is recognition that managers do not have sufficient knowledge to optimize capital structure with any real precision. The literature critique in this paper i) identifies the conceptual sources of the main empirical failures of the leading models of capital structure and ii) shows how those failures can be repaired by taking into account imperfect managerial knowledge and several other factors. The analysis yields a compact set of principles for thinking about capital structure in an empirically supported way.

This article documents new and empirically important interactions between cash-balance and leverage dynamics. Cash ratios typically vary widely over extended horizons, with dynamics remarkably similar to (and complementary with) those of capital structure. Leverage and cash dynamics interact approximately as predicted by the internal-versus-external funding regimes in Myers and Majluf (1984, J. Finan. Econ., 13, 187–221.). Leverage is quite volatile when cash ratios are stable and vice-versa, while net-debt ratios are almost always volatile. Most firms increase leverage sharply as cash balances (internal funds) become scarce. Capital structure models that extend Hennessy and Whited (2005, J. Finan., 60, 1129–1165.) to include cash-balance dynamics explain some, but not all, aspects of the observed relation between cash squeezes and leverage increases.