We develop a dynamic tradeoff model to examine the importance of manager–shareholder conflicts in capital structure choice. In the model, firms face taxation, refinancing costs, and liquidation costs. Managers own a fraction of the firms’ equity, capture part of the free cash flow to equity as private benefits, and have control over financing decisions. Using data on leverage choices and the model's predictions for different statistical moments of leverage, we find that agency costs of 1.5% of equity value on average are sufficient to resolve the low‐leverage puzzle and to explain the dynamics of leverage ratios. Our estimates also reveal that agency costs vary significantly across firms and correlate with commonly used proxies for corporate governance.

This paper develops a real options framework to analyze the behavior of stock returns in mergers and acquisitions. In this framework, the timing and terms of takeovers are endogenous and result from value‐maximizing decisions. The implications of the model for abnormal announcement returns are consistent with the available empirical evidence. In addition, the model generates new predictions regarding the dynamics of firm‐level betas for the period surrounding control transactions. Using a sample of 1,086 takeovers of publicly traded U.S. firms between 1985 and 2002, we present new evidence on the dynamics of firm‐level betas, which is strongly supportive of the model's predictions.