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Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure

Published online by Cambridge University Press:  06 April 2009

Nengjiu Ju ,
Robert Parrino ,
Allen M. Poteshman  and
Michael S. Weisbach
Nengjiu Ju
Affiliation:
nengjiu@ust.hk, Department of Finance, Hong Kong University of Science and Technology, Hong Kong
Robert Parrino
Affiliation:
parrino@mail.utexas.edu, Department of Finance, McCombs School of Business, University of Texas at Austin, Austin, TX 78712
Allen M. Poteshman
Affiliation:
poteshma@uiuc.edu, Department of Finance, College of Business, University of Illinois, Champaign, IL 61820.
Michael S. Weisbach
Affiliation:
weisbach@uiuc.edu, Department of Finance, College of Business, University of Illinois, Champaign, IL 61820.
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Abstract

This paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics. The model uses contingent claim methods to value interest tax shields, allows for reorganization in bankruptcy, and maintains a long-run target debt to total capital ratio by refinancing maturing debt. Using this model, we calculate optimal capital structures in a realistic representation of the traditional trade-off model. In contrast to previous research, the calculated optimal capital structures do not imply that firms tend to use too little leverage in practice. We also estimate the costs borne by a firm whose capital structure deviates from its optimal target debt to total capital ratio. The costs of moderate deviations are relatively small, suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 40 , Issue 2 , June 2005 , pp. 259 - 281
Copyright
Copyright © School of Business Administration, University of Washington 2005

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