In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade‐off model to simulate firms' capital structure paths. The results of standard cross‐sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.

Do strategic actions of borrowers and lenders affect corporate debt values? We find higher bond spreads for firms that can renegotiate debt contracts relatively easily. Consistent with theories of strategic debt service, the threat of strategic default depresses bond values ex ante, even though there may be efficiency gains from renegotiation ex post. However, the economic significance of the net effect is small, suggesting that bondholders have considerable bargaining power. The effect of strategic actions is higher when creditors are particularly vulnerable to strategic threats, including risky firms with high managerial shareholding, simple debt structures, and high liquidation costs.