Do Firms Adjust Capital Structures to Manage Risk

We provide a new insight on how changes in risk affect a firm’s capital structure decisions. Using an approach that alleviates potential problems caused by high capital structure adjustment costs, we test whether firms that experience a substantial increase in risk choose an external financing method that is consistent with the implications of dynamic trade-off theories of capital structure. We find that these firms indeed choose a financing method that lowers their leverage ratios. This finding is particularly pronounced for firms with a high level of risk or firms that raise a large amount of external capital, and is robust to a variety of risk measures such as stock return volatility, default probability and implied asset volatility based on the Merton (1974) model, and an adjusted Ohlson (1980) score.