When firms adjust their capital structures, they tend to move toward a target debt ratio that is consistent with theories based on tradeoffs between the costs and benefits of debt. In contrast to previous empirical work, out tests explicitly account for the fact that firms may face impediments to movements toward their target ratio, and that the target ratio may change over time as the firm's profitability and stock price change. A separate analysis of the size of the issue and repurchase transactions suggests that the deviation between the actual and the target ratios plays a more important role in the repurchase decision than in the issuance decision.

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.

Unless priced and administered appropriately, a governmental safety net enhances risk‐shifting opportunities for banks. This paper quantifies regulatory efforts to use capital requirements to control risk‐shifting by U.S. banks during 1985 to 1994 and investigates how much risk‐based capital requirements and other deposit‐insurance reforms improved this control. We find that capital discipline did not prevent large banks from shifting risk onto the safety net. Banks with low capital and debt‐to‐deposits ratios overcame outside discipline better than other banks. Mandates introduced by 1991 legislation have improved but did not establish full regulatory control over bank risk‐shifting incentives.