In this paper, I investigate the logic behind cross sectional dispersion of firm\u27s capital structure. I incorporate the trade off between tax benefits and financial distress costs into a dynamic general equilibrium model with heterogeneous firms and their endogenous entry/exit, and compute an equilibrium firm distribution.
The main findings are summarized as follows. First, I find that the equilibrium distribution approximates the dispersion of firms\u27 capital structure well. Second, I find that it simultaneously accounts for the relationship of capital structure to profitability \textit{and} firm size. The key mechanisms are the difference in responses to persistent and transitory productivity shocks and economies of scale. Third, I find through counterfactual experiments that even if the tax benefits do not exist, firms would not significantly change their capital structure in contrast to previous works. The intuition is that, with firm\u27s entry/exit, young firms always exist and use debt until they accumulate internal funding
