Capital structure theory and the prediction of bankruptcy

This paper addresses the theoretical foundations of bankruptcy prediction, using the neo-classical theory of capital structure as a starting point. The paper intends to demonstrate the feasibility of such an approach in a simple setting, i.e. by using a simple theoretical model and a limited empirical analysis. A model of optimal capital structure is constructed and rewritten as a model of default probability. Its empirical implications are derived and tested on a sample of Norwegian data. It is concluded that this approach clearly has its limitations, but also that it may be a valuable contribution compared to the multitude of theory-less empirical studies and a useful alternative to the default theory based on option pricing.