Optimal Capital Structure and Investment with Real Options and Endogenous Debt Costs

Praveen Kumar and Vijay Yerramilli

The Review of Financial Studies, 2018, vol. 31, issue 9, 3452-3490

Abstract: We examine the joint optimization of financial leverage and irreversible capacity investment in a real options framework with risky debt and endogenous interest costs. Higher capacity, ceteris paribus, increases operating leverage and default probability, but lowers ex post adjustment costs and generates larger tax shields. A key insight is that financial leverage and capacity are substitutes in the debt market equilibrium. We develop novel predictions about the effects of capital adjustment costs, operating costs, and uncertainty on optimal financial leverage and capacity that may potentially help explain ambiguous empirical results in the literature regarding the determinants of capital structure and investment. Received March 17, 2016; editorial decision July 8, 2017 by Editor Itay Goldstein.

Date: 2018
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