Do Tests of Capital Structure Theory Mean What They Say?



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    • Strebulaev is at the Graduate School of Business, Stanford University. Most of the work on this paper was carried out at the London Business School. I wish to acknowledge with deep gratitude the counsel and never-failing kindness of Steve Schaefer. I am much obliged for many illuminating conversations and constructive suggestions to an associate editor, an anonymous referee, Viral Acharya, Anat Admati, Nick Barberis, Dick Brealey, Ian Cooper, Sergei Davydenko, Paul G. Ellis, David Goldreich, Denis Gromb, Rajiv Guha, Tim Johnson, Jan Mahrt-Smith, Pierre Mella-Barral, Felix Meschke, Kjell Nyborg, Sergey Sanzhar, Robert Stambaugh (the editor), Alexander Triantis, Raman Uppal, Rang Wang, Ivo Welch, and Toni Whited, and to the seminar participants at the Anderson School of Business at UCLA, Cambridge, Carnegie-Mellon, Columbia Business School, Cornell, Harvard Business School, Goizueta Business School, Kellogg, London Business School, Michigan Business School, McCombs School of Business, Oxford, Simon School of Business, Stanford GSB, and Stern School of Business. I am also thankful to the participants of the Western Finance Association 2004 meeting in Vancouver and the European Finance Association 2004 meeting in Maastricht. I am solely responsible for all remaining errors.


In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms' capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.