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Debt Dynamics




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    • Hennessy is from the University of California at Berkeley. Whited is from the University of Wisconsin, Madison. We would like to thank an anonymous referee, Rob Stambaugh, Alan Auerbach, Joao Gomes, Gilles Chemla, Tom George, Terry Hendershott, Dirk Jenter, Malcolm Baker, Murray Frank, Sheridan Titman, and JonathanWillis for detailed comments. We also thank seminar participants at the Federal Reserve Board, MIT, the University of British Columbia, and the University of Houston.


We develop a dynamic trade-off model with endogenous choice of leverage, distributions, and real investment in the presence of a graduated corporate income tax, individual taxes on interest and corporate distributions, financial distress costs, and equity flotation costs. We explain several empirical findings inconsistent with the static trade-off theory. We show there is no target leverage ratio, firms can be savers or heavily levered, leverage is path dependent, leverage is decreasing in lagged liquidity, and leverage varies negatively with an external finance weighted average Q. Using estimates of structural parameters, we find that simulated model moments match data moments.