A Dynamic Model of Optimal Capital Structure
University of South Carolina - Darla Moore School of Business
University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)
November 25, 2005
McCombs Research Paper Series No. FIN-03-06
This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. The model extends the dynamic capital structure literature by endogenizing the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the capital structure choice affects both target debt ratios and the extent to which actual debt ratios deviate from their targets. In particular, we examine how financial distress and the firm's objectives, i.e., whether it makes choices to maximize total firm value versus equity value, influence the extent to which firms make financing choices that move them towards their target debt ratios.
Number of Pages in PDF File: 64
Keywords: capital structure, investments, tradeoff, pecking order, market timing, mean-reversion, adjustment rate, depreciation rate, gold mining companies, transaction costs.
JEL Classification: G3, G30, G31, G32, G33, G34, G35
Date posted: November 19, 2002