Are Corporate Default Probabilities Consistent with the Static Tradeoff Theory?
Review of Financial Studies, Forthcoming
Posted: 23 Jul 2011
Date Written: July 22, 2011
Default probability plays a central role in the static tradeoff theory of capital structure. We directly test this theory by regressing the probability of default on proxies for costs and benefits of debt. Contrary to predictions of the theory, firms with higher bankruptcy costs, i.e., smaller firms and firms with lower asset tangibility, choose capital structures with higher bankruptcy risk. Further analysis suggests that the capital structures of smaller firms with lower asset tangibility, which tend to have less access to capital markets, are more sensitive to negative profitability and equity value shocks, making them more susceptible to bankruptcy risk.
Keywords: capital structure, tradeoff theory, default probability
JEL Classification: G32
Suggested Citation: Suggested Citation