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

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  • Praveen Kumar
  • Vijay Yerramilli

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. Received March 17, 2016; editorial decision July 8, 2017 by Editor Itay Goldstein.

Suggested Citation

  • Praveen Kumar & Vijay Yerramilli, 2018. "Optimal Capital Structure and Investment with Real Options and Endogenous Debt Costs," The Review of Financial Studies, Society for Financial Studies, vol. 31(9), pages 3452-3490.
    • Handle: RePEc:oup:rfinst:v:31:y:2018:i:9:p:3452-3490.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhx093
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    Cited by:

    1. Gorupec Natalia & Tiberius Victor & Brehmer Nataliia & Kraus Sascha, 2022. "Tackling uncertain future scenarios with real options: A review and research framework," The Irish Journal of Management, Sciendo, vol. 41(1), pages 69-88, July.
    2. Iván Arribas & Emili Tortosa-Ausina & TingTing Zhu, 2021. "Optimal capital structure, model uncertainty, and European SMEs," Working Papers 2021/11, Economics Department, Universitat Jaume I, Castellón (Spain).

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