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

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.