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

Author

Listed:
  • Ju, Nengjiu
  • Parrino, Robert
  • Poteshman, Allen M.
  • Weisbach, Michael S.

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.

Suggested Citation

  • Ju, Nengjiu & Parrino, Robert & Poteshman, Allen M. & Weisbach, Michael S., 2005. "Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 40(02), pages 259-281, June.
  • Handle: RePEc:cup:jfinqa:v:40:y:2005:i:02:p:259-281_00
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    Cited by:

    1. Chen, Chang-Chih & Shyu, So-De & Yang, Chih-Yuan, 2011. "Counterparty effects on capital structure decision in incomplete market," Economic Modelling, Elsevier, vol. 28(5), pages 2181-2189, September.
    2. repec:eee:reveco:v:49:y:2017:i:c:p:596-611 is not listed on IDEAS
    3. Platt Harlan D, 2009. "The Private Equity Myth," Journal of Business Valuation and Economic Loss Analysis, De Gruyter, vol. 4(1), pages 1-19, October.
    4. Dang, Viet Anh, 2013. "An empirical analysis of zero-leverage firms: New evidence from the UK," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 189-202.
    5. repec:ers:journl:v:xx:y:2017:i:3b:p:176-186 is not listed on IDEAS
    6. repec:eee:jebusi:v:96:y:2018:i:c:p:1-14 is not listed on IDEAS
    7. Miglo, Anton, 2010. "The Pecking Order, Trade-off, Signaling, and Market-Timing Theories of Capital Structure: a Review," MPRA Paper 46691, University Library of Munich, Germany, revised 2013.
    8. Lai, Van Son & Soumaré, Issouf, 2010. "Credit insurance and investment: A contingent claims analysis approach," International Review of Financial Analysis, Elsevier, vol. 19(2), pages 98-107, March.
    9. Bessler, Wolfgang & Drobetz, Wolfgang & Haller, Rebekka & Meier, Iwan, 2013. "The international zero-leverage phenomenon," Journal of Corporate Finance, Elsevier, vol. 23(C), pages 196-221.
    10. Attaoui, Sami & Poncet, Patrice, 2015. "Write-Down Bonds and Capital and Debt Structures," Journal of Corporate Finance, Elsevier, vol. 35(C), pages 97-119.
    11. Sami Attaoui, 2016. "Capital Structure And Tax Convexity When The Maturity Of Debt Is Finite," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(01), pages 1-20, February.
    12. repec:abd:kauiea:v:30:y:2017:i:1:p:105-116 is not listed on IDEAS
    13. William Gornall & Ilya A. Strebulaev, 2013. "Financing as a Supply Chain: The Capital Structure of Banks and Borrowers," NBER Working Papers 19633, National Bureau of Economic Research, Inc.
    14. Sabiwalsky, Ralf, 2010. "Nonlinear modelling of target leverage with latent determinant variables -- new evidence on the trade-off theory," Review of Financial Economics, Elsevier, vol. 19(4), pages 137-150, October.
    15. Cook, Douglas O. & Kieschnick, Robert & McCullough, B.D., 2008. "Regression analysis of proportions in finance with self selection," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 860-867, December.
    16. Correia, Ricardo & Población, Javier, 2015. "A structural model with Explicit Distress," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 112-130.
    17. Perrakis, Stylianos & Zhong, Rui, 2015. "Credit spreads and state-dependent volatility: Theory and empirical evidence," Journal of Banking & Finance, Elsevier, vol. 55(C), pages 215-231.

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