How Investment Opportunities Impact Optimal Capital Structure

Abstract

This article addresses the question of how competition for investments among firms in a certain industry impacts their capital structure. We develop a new modelling framework, which simulates financial variables of a set of firms in a given sector. We use it to analyse how firms are competing for new investments. The leverage of the firm impacts its flexibility to react upon investment opportunities, and we show how it can be optimised to maximise the firm’s growth. As an illustration, we then apply the model on a set of European airlines and global pharmaceutical companies. The novelty that this paper introduces is the explicit modelling of the interaction among several companies. Invariably, the literature on optimal capital structure focuses on a single company optimising its capital structure in a world where the actions of its competitors are exogenous. Corporate Finance theory states that the optimisation of investment opportunities is one of three drivers of optimal leverage (together with reduction of the distress costs or tax expenditures). Our results suggest that the optimal capital structure should incorporate the competitive position of the firm as well as the availability of investment opportunities. Our framework allows corporate decision makers (CEOs and CFOs) to incorporate these aspects in their decision making.

Our main conclusion is that the leverage of the company impacts its ability to capture investment opportunities in a world where such opportunities are scarce. Companies with very low or very high leverage have reduced flexibility to invest, due to a high hurdle rate. Reducing the volatility of cash flows via hedging generally improves the ability to invest. The ability to invest in random growth opportunities is particularly important in mature industries, where investment opportunities are limited. Finally, if more flexible companies exploit investment opportunities this reduces the investment options for their less flexible competitors.

Keywords: Modigliani-Miller, corporate investment policy, capital structure, WACC, hurdle rate, financial flexibility, Monte Carlo simulation, optimal leverage

JEL Classification: G31, G32