Optimal Capital Structure and Industry Dynamics

This paper presents an equilibrium model of industry dynamics and capital structure decisions. The unique stationary equilibrium is derived in closed-form. The analysis reveals that the interaction between capital structure and production decisions influences the stationary distribution of surviving firms and their survival probabilities. Under reasonably calibrated parameter values, the model predicts a low industry average leverage ratio which is in line with that observed in practice. Comparative static analysis demonstrates that the model can generate the relation between capital structure and firms¡¯ entry, exit and production decisions documented in the evidence. The model also provides a number of new predictions regarding industry dynamics and capital structure.