On the debt Capacityof growth Options
If debt capacity is defined as the incremental debt that is optimally associated with an additional asset, then the debt capacity of growth options is negative. Underinvestment costs of debt increase and free cash flow benefits of debt fall with additional growth options. Thus, if firm value increases with additional growth options, then leverage not only declines, but the firm’s optimal total debt level declines as well. This result implies a negative relation between book leverage and growth options and provides a new economic interpretation of book leverage regressions.
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