We develop a dynamic trade‐off model with endogenous choice of leverage, distributions, and real investment in the presence of a graduated corporate income tax, individual taxes on interest and corporate distributions, financial distress costs, and equity flotation costs. We explain several empirical findings inconsistent with the static trade‐off theory. We show there is no target leverage ratio, firms can be savers or heavily levered, leverage is path dependent, leverage is decreasing in lagged liquidity, and leverage varies negatively with an external finance weighted average Q . Using estimates of structural parameters, we find that simulated model moments match data moments.

As an alternative to the pecking order, we develop a dynamic calibratable model where the firm avoids mispricing via signaling. The model is rich, featuring endogenous invest-ment, debt, default, dividends, equity flotations, and share repurchases. In equilibrium, firms with negative private information have negative leverage, issue equity, and overin-vest. Firms signal positive information by substituting debt for equity. Default costs induce such firms to underinvest. Model simulations reveal that repeated signaling can account for countercyclical leverage, leverage persistence, volatile procylical investment, and correla-tion between size and leverage. The model generates other novel predictions. Investment rates are the key predictor of abnormal announcement returns in simulated data, with lever-age only predicting returns unconditionally. Firms facing asymmetric information actually exhibit higher mean Q ratios and investment rates. (JEL G32) Three decades have passed since Leland and Pyle (1977) and Ross (1977) de-veloped the signaling theory of corporate finance. Although their work has been extended, signaling models remain static and qualitative, making it im-possible for empiricists to assess the theory’s ability to match observed time-

We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.