Are Corporate Default Probabilities Consistent with the Static Trade-off Theory?

Armen Hovakimian, Ayla Kayhan, Sheridan Titman
2011 The Review of financial studies  
Default probability plays a central role in the static trade-off 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
more » ... ch tend to have less access to capital marketsare more sensitive to negative profitability and equity value shocks, making them more susceptible to bankruptcy risk. (JEL G32) The probability of bankruptcy plays a central role in what is generally referred to as the static trade-off theory of capital structure. This theory, which postulates that firms choose their capital structures by trading off the benefits of debt financing (e.g., tax shields) against the costs associated with financial distress and bankruptcy, has been tested in the past by regressing various debt ratios on firm characteristics that proxy for the costs of bankruptcy and the tax benefits of debt. As we argue in this article, regressions of firm-level Standard For their comments, we thank Mike Weisbach
doi:10.1093/rfs/hhr101 fatcat:ze6glur6enempprk5rrxa45oia