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

Forthcoming, Review of Financial Studies

56 Pages Posted: 16 Aug 2017

See all articles by Praveen Kumar

Praveen Kumar

University of Houston - Department of Finance

Vijay Yerramilli

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

Date Written: July 1, 2017

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.

Keywords: Capital Structure; Operating Leverage; Capacity Investment; Real Options; Adjustment Costs

JEL Classification: G31; G32; G33; D24

Suggested Citation

Kumar, Praveen and Yerramilli, Vijay, Optimal Capital Structure and Investment with Real Options and Endogenous Debt Costs (July 1, 2017). Forthcoming, Review of Financial Studies. Available at SSRN: https://ssrn.com/abstract=3018648

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)

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