Are Corporate Default Probabilities Consistent with the Static Trade-off Theory?

Default probability plays a central role in the static trade-off theory of capital structure. We directly test this theory by regressing the probability of default on proxies for costs and benefits of debt. Contrary to predictions of the theory, firms with higher bankruptcy costs, i.e., smaller firms and firms with lower asset tangibility, choose capital structures with higher bankruptcy risk. Further analysis suggests that the capital structures of smaller firms with lower asset tangibility-which tend to have less access to capital markets-are more sensitive to negative profitability and equity value shocks, making them more susceptible to bankruptcy risk. (JEL G32)