Testing the Trade-off Theory of Capital Structure

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. We also predict greater negative stock returns for firms with lower capacity to service debt. We use stock price declines after the terrorist attacks of 2001 to test this prediction. Our sample consists of 2,137 U.S. manufacturing firms. For our analysis, we use both portfolio and individual cumulative abnormal returns for three days after the terrorist attacks. Findings of the study support our predictions: firms with high level of debt (especially long-term debt) and a lower capacity to service debt experienced greater negative abnormal returns in the three days after the terrorist attacks.