Optimal Financial and Operating Leverage with Real Options

47 Pages Posted: 20 Nov 2012 Last revised: 19 Mar 2016

Praveen Kumar

University of Houston - Department of Finance

Vijay Yerramilli

University of Houston, C. T. Bauer College of Business

Date Written: March 17, 2016

Abstract

We analyze the optimal capacity investment (or operating leverage) and financial leverage policies with irreversible investment in the presence of financial distress and capacity expansion costs. In a loan market equilibrium with endogenous default, financial and operating leverage may either be substitutes or complements depending on the magnitude of expansion costs and whether the marginal tax rate exceeds marginal distress costs. Consequently, the relation of financial leverage and cash-flow uncertainty can be complex, consistent with empirical evidence. We generate novel predictions on the effects of financial and technological parameters on the cross-sectional variation in financial and operating leverage, and book-to-market.

Keywords: Operating Leverage; Financial Leverage; Real Options; Uncertainty; Capacity Expansion

JEL Classification: G31, G32, D24, D81

Suggested Citation

Kumar, Praveen and Yerramilli, Vijay, Optimal Financial and Operating Leverage with Real Options (March 17, 2016). Available at SSRN: https://ssrn.com/abstract=2178266 or http://dx.doi.org/10.2139/ssrn.2178266

Praveen Kumar

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States
713-743-4770 (Phone)
713-743-4789 (Fax)

Vijay Yerramilli (Contact Author)

University of Houston, C. T. Bauer College of Business ( email )

Houston, TX 77204
United States
713-743-2516 (Phone)

Paper statistics

Downloads
106
Rank
209,893
Abstract Views
595