On the Debt Capacity of Growth Options

31 Pages Posted: 6 Sep 2001

See all articles by Michael J. Barclay

Michael J. Barclay

University of Rochester - Simon School (Deceased)

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Clifford W. Smith

Simon Graduate School of Business, University of Rochester

Date Written: June 2001

Abstract

We relate the value of growth options in the firm's investment opportunity set to the level of debt in the firm's capital structure. Underinestment costs of debt increase and free cash flow benefits fall with additional growth options. Thus, if debt capacity is defined as the amount of debt the firm optimally adds for an incremental project, then the debt capacity of growth options is negative. This result implies that book leverage should fall with the addition of growth options. Our tests, using a large sample of industrial firms, confirm this prediction.

Keywords: Growth Options, Book Leverage

JEL Classification: G31, G32

Suggested Citation

Barclay, Michael J. and Morellec, Erwan and Smith, Clifford W., On the Debt Capacity of Growth Options (June 2001). Simon School of Business Working Paper No. FR 01-07. Available at SSRN: https://ssrn.com/abstract=271949 or http://dx.doi.org/10.2139/ssrn.271949

Michael J. Barclay (Contact Author)

University of Rochester - Simon School (Deceased)

N/A

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne ( email )

College of Management
Extranef Quartier UNIL-Dorigny
1015 Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Clifford W. Smith

Simon Graduate School of Business, University of Rochester ( email )

Carol Simon Hall 3-202C
Rochester, NY 14627
United States
585-275-3217 (Phone)
585-442-6323 (Fax)

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