This paper shows how a firm’s expectation about costs of external financing in distress will affect its leverage choice at time-zero. A firm is very conservative in its leverage policy ex-ante if it knows that costs of external financing will grow with leverage. Such a model can resolve the underleverage and distress puzzles in cases where bankruptcy costs are only 10% of the firm’s assets value. In contrast, a firm’s initial leverage is much higher in a model in which external financing costs are constant, even if they are as high as 30 cents per dollar raised. To resolve the puzzles in the latter model, bankruptcy costs should exceed 50%.