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

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. (JEL G31, G32, G33, D24) ∗An earlier version of the paper was titled “Optimal Operating Capacity and Risk with Real Options and Financial Frictions.” We thank two anonymous referees, Itay Goldstein (Editor), Sugato Bhattacharya, Paolo Fulghieri, Tom George, Dirk Hackbarth, Paul Povel, Adriano Rampini, Norman Schurhoff, Giorgo Sertsios, Bart Taub (discussant), and Toni Whited and the seminar participants at the University of Houston and the 2014 SFS Cavalcade for their helpful comments or discussions on issues examined in the paper. We also thank Dimuthu Ratnadiwakara for valuable research assistance. All remaining errors are our responsibility. Send correspondence to Vijay Yerramilli, 334 Melcher Hall, University of Houston, Houston, TX 77204; telephone: (713) 743-2516. E-mail: [email protected]. Firms are levered because of both their financial and operational choices. It has long been recognized that both debt repayment costs and fixed operating costs, which are determined by the firm’s operating capacity, are important in levering the exposure of assets to economic risks (e.g., Lev 1974; Novy-Marx 2011). Hence, the trade-off between financial and operating leverage is of substantial interest because many firms simultaneously face both financial frictions and technological frictions, such as capital irreversibility and adjustment costs. Although a number of studies in the broader corporate finance literature endogenize both capital structure and investment, we still have a limited understanding of the trade-offs involved in the choice of financial and operating leverage. In this paper, we examine the joint optimization of financial leverage and irreversible investment in a real options framework with risky debt financing, where shareholders may strategically default on their debt obligations, and the cost of debt is determined endogenously. We examine a three-period model. In the first period, shareholders choose irreversible capacity investment and financial leverage to maximize equity value when future profits are uncertain. Similar to other models of operating leverage in the literature (e.g., Carlson, Fisher, and Giammarino 2004), capacity investment is positively related to the firm’s operating leverage because of the presence of fixed operating costs that increase with capacity. In the second period, conditional on the realization of a profit shock and the prior decisions, the firm may choose to default, or to continue operation at the installed capacity, or to expand capacity by incurring capital adjustment costs and additional financing costs. Debt generates interest tax shields but exposes the firm to the risk of costly default because of the presence of deadweight bankruptcy costs, and the cost of debt is endogenously determined by a competitive loan market. We characterize the firm’s optimal financial leverage and capacity investment policies in a perfect Bayesian equilibrium in which shareholders follow their dynamically consistent production and default strategies in the second period. Consistent with the literature on