Testing the Trade-off Theory of Capital Structure‪.‬

Executive Summary We test the trade-off theory of capital structure in a setting in which a crisis suddenly changes the probability of bankruptcy. In this setting, the trade-off theory of capital structure predicts that the optimum level of capital structure would shift to a lower level of debt, and thus would lead to a negative market reaction for a firm at its optimum level of debt. Because the optimum level of debt is unobservable, we predict that the level of debt affects the market reaction. In other words, we predict that firms with higher level of debt will experience greater negative stock returns.