Robust Leverage Dynamics under Costly Equity Issuance

We develop a dynamic capital structure model featuring downward jump shocks and costly external equity to quantify the impact of shareholder ambiguity aversion. We show that ambiguity fundamentally reshapes financial policy by eroding the firm's going-concern value, generating three distinct regimes. Under low ambiguity, firms actively recapitalize to avoid costly default. As ambiguity increases to moderate levels, the incentive to issue equity vanishes, and firms drift passively toward wipe-out recapitalization, providing a theoretical explanation for the empirical puzzle of equity issuance inertia among distressed firms. Under high ambiguity, firms become economically insolvent, and debt capacity collapses to the liquidation floor. Target leverage exhibits a U-shaped response to ambiguity, reflecting the interaction between precautionary buffer-building and value extraction. Furthermore, ambiguity also eliminates the incentive to gamble for resurrection. By amplifying pessimistic belief distortions, it renders the firm globally risk-averse and overturns the standard option-value prediction: higher earnings volatility accelerates rather than delays default.