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Bankruptcy Risk and Optimal Capital Structure

Authors

  • RICHARD CASTANIAS

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    • Assistant Professor of Finance, Graduate School of Administration, University of California, Davis, California 95616. The author is grateful for comments and suggestions concerning earlier drafts from Ed Rice, Paul Malatesta, Alan Hess, Harry DeAngelo, Michael Brennan and an anonymous referee at the Journal of Finance.

ABSTRACT

This study finds shortcomings in empirical tests of the capital structure irrelevance hypothesis. The alternative hypothesis is that firms choose value maximizing mixes of debt and equity on account of bankruptcy costs and the tax deductibility of interest payments. Based upon the cross-sectional implications of the tax shelter-bankruptcy cost hypothesis, an alternative test of the irrelevance hypothesis is performed. The test examines the relationship between failure rates and leverage ratios for 36 lines of business. The results are inconsistent with the irrelevance hypothesis.

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