Financial Leverage Strategy with Transaction Costs
Applied Mathematical Finance, Vol. 3, pp. 191-208, 1996
18 Pages Posted: 28 Jan 2008 Last revised: 8 Oct 2013
Abstract
This is a sequel to our paper Pecking Order as a Dynamic Leverage Theory, European Journal of Finance 4, 1998, 157-183. Here we offers a class of diffusion models that mimic the firm's pecking order behavior and are designed to optimize an intertemporal leverage strategy under a more complex scenario of both fixed and variable refinancing transaction costs. The proposed class of models is compatible with traditional static tradeoff theories and can be used to recast those theories in a dynamic framework by superimposing refinancing costs. We derive analytical expressions for the parameters of an optimal leverage strategy with exogenous refinancing limits, including the minimum cost of capital in a stochastic dynamic framework with transaction costs, target values to which the leverage should be readjusted when the limits are reached, and the mean leverage implied by the optimal strategy. Our class of models enriches the pecking order theory and provides a quantitative framework for its implementation as a decision tool. It also provides additional hypotheses for empirical validation of that theory. Symmetrically, our results show the importance of dynamic factors in designing and interpreting empirical tests of static tradeoff theories.
Keywords: financial leverage strategy, dynamic diffusion model, pecking order theory, financial leverage estimation
JEL Classification: G32, G31, C61
Suggested Citation: Suggested Citation